Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

16.4.2 Introducing Activity-Based Costing: Aim, Basic Premise, Requirements, and Technique

Intended learning outcomes: Produce an overview on activity-based costing. Identify ABC process, process variable and process cost rate. Describe the ABC process plan and the process quantity. Explain allocating fixed costs using activity-based cost accounting.

Activity-based costing, or activity-based cost accounting (ABC), is a cost accounting system designed to allocate fixed costs (overhead) as fairly and realistically as possible to the business processes.

The aim of activity-based costing is thus essentially not new. However, achievement of the aim means better performance on the following tasks:

  • Process management: Planned investments can be linked to specific processes right from the outset. The resulting investment costs can be converted into corresponding process costs and then compared with the previous process costs.
  • Support for decision making in product design: Developers are informed of the consequences of their choice of purchased components or new design and manufacturing processes at a very early stage. This information usually provides a comparison of different technologies or shows the consequences of changing the product design. This type of information is very important, for cost of a product has essentially been determined by the end of the design phase. After that, very little can be done to influence cost.
  • Product cost estimation: Activity-based costing, just like conventional costing, is a useful technique for estimating costs. Pricing will be much more accurate if the costs are estimated correctly.

With respect to the basic premise behind activity-based costing, the need for a “fair” distribution formula for overhead also means finding a suitable measurement, or allocation base. For this reason, we need to examine our fixed costs in greater detail, tracing them back to the underlying processes — or even subprocesses or individual activities. In Section 16.1.4, we demonstrated how fixed material costs can be calculated differently for different groups of materials or cost centers. This is one step toward the principle illustrated below.

An ABC process is a process or activity that incurs extensive fixed costs in the company and thus is allocated to business processes using ABC.

The process variable is a unit against which we can measure the costs for the ABC process or activity in a suitable manner.
This is called the activity cost driver. ABC uses activity cost drivers to allocate the costs to cost objects, such as products, in relation to the resources consumed.

In most cases, the activity cost driver is not associated with variable costs or an underlying time unit. Instead, activity cost drivers are, for example, the number of purchase orders, the number of items received, or the number of components for an assembly. If business processes or activities are identified and broken down with sufficient detail into subprocesses, the cost driver is usually easy to identify the fixed costs can now be related to the products by using the cost drivers. The methods used here are similar to those that were used in traditional time studies in process planning for establishing time standards: count, measure, and calculate average.

The process cost rate, or planned cost rate, for every ABC (sub-)process is the cost rate for an activity cost driver.

An ABC process or subprocess thus not only represents an actual process. Together with its process cost rate, it also represents a traditional work center or cost center and the associated cost rate. Processes can also be recorded in this way, especially in IT-supported systems.

The ABC process plan for each product is a list of all the ABC processes (activities) that a product requires while it is being produced or procured.

The process quantity is the quantity as measured by the activity cost drivers that is likely to be used in an ABC process for the product.

The structure of an ABC process plan is similar to that of a routing sheet (see Section 1.2.3).[note 1603] One ABC process plan position is assigned to every ABC process required to produce or procure the product. These positions correspond to the operations. The process quantity corresponds to the standard load of an operation. This means that we can keep ABC process plans in exactly the same way as routing sheets, particularly if the system is IT supported.

Activity-based costing is thus based on the calculation of standard cost rates. The requirement for such activity-based costing is that the ABC processes must be clearly measurable and repetitive (see Section 16.1.2). Such processes can be found in the operational management of an organization, in logistics, and in accounting. It is in these areas that activity-based costing can be implemented successfully. The technique is more difficult to implement at the strategic level, since few repetitive ABC processes can be identified at this level (or, if they do exist, they relate to an extremely long period of time). Even if we could identify an activity cost driver, it would still not be possible to accurately determine the process quantity per product, that is, the usage of process variables.

Figure shows several examples of processes (activities) and process variables (activity cost drivers) in the areas of purchasing and production.

Fig.       Allocating fixed costs using activity-based cost accounting.

Examples of process cost rates associated with the process variables in Figure are

  • x dollars per order
  • y dollars per item in receiving
  • z dollars per component in assembly
  • u dollars per run time unit in the testing process

The separation of tooling costs from fixed internal manufacturing costs described in Section 16.1.4 is one example of activity-based costing. There, the (ABC) process of tool utilization is considered separately. The activity cost driver may be the same as the tool utilization time or even, as suggested, simply the use of that tool to manufacture one unit of the batch.

To introduce activity-based costing into the company, the following steps are necessary:

1.    Determine the areas in which activity-based costing is to be used.

2.    Determine the ABC processes, broken down into subprocesses (activities). A meaningful ABC (sub-)process has at least the following characteristics:

  •             The costs of the process are significant.
  •             The process corresponds to a specific task within the process organization.
  •             The various products (cost objects) should use the process to varying degrees (different process quantities).

3.    Determine the process variable (activity cost driver) for each process. A good process variable has at least the following characteristics:

  •             It is so closely related to the process costs that the process quantities can be based upon this unit variable.
  •             It is self-explanatory to the people concerned within the organization, since it appears to be a natural variable within the operational process.
  •             It should also appear to be a natural variable when options for different design variants or production methods are compared against one another.
  •             The process quantities and cost rate per unit (process cost rate or process rate) can, as far as possible, be automatically calculated from the operational data.

4.    Determine the process cost rate for each ABC process. This is done by dividing the fixed costs resulting from the process by the likely future process quantities.

5.    Specify the ABC process plan for each product and the process quantity for each ABC process in the ABC process plan.

6.    Calculate the process costs for the product by analyzing the ABC process plan (and the bill of material, of course) with the same algorithm used for production or procurement costs calculated using the traditional order costs or job order costing technique (see Section 16.2).

7.    Job-order costing and analyzing variances: As in conventional costing, the volume variance can now be calculated for a particular order by recording the actual usage of process variables. Activity-based costing should thus identify any deviation from planned unit cost rates and compare actual process costs against the budgeted costs. This type of measurement is rather illusory, however, since small process quantities would take much too long to measure.

Course section 16.4: Subsections and their intended learning outcomes

  • 16.4.4 Activity-Based Product Cost Estimation

    Intended learning outcomes: Produce an overview on Determining the process cost rate and process quantity for supplier management. Explain determining the process cost rate as well as the process costs for external procurement of a single item: “standard component” versus “exotic component.” Present in detail an ABC process plan and activity-based product cost estimation for a produced item as well as for a procured item.