Traditional cost systems, using only unit-cost drivers such as direct labor hours, cannot capture the accurate cost of multi-product production process. Activity-based cost systems hence are required for more accurate cost information about business activities and of the product and services and customers served by these processes. ABC systems focus on organizational activities for the analysis of cost behavior by linking spending on resources to the activities on which this spending is done.

If we study the cost pattern of two factories: Single (manufacturing a volume of pens of same colored ink pens) and Multi (manufacturing the same volume as Single but constituting various colored ink pens), a Multi factory will differ from resources and activities in Single factory in following aspects:

Requires many more resources to support its high variety mix Much larger production staff to schedule machine and production work Negotiate with vendors Receive and inspect incoming materials and parts Higher levels of idle time, setup time, overtime inventory etc.

Therefore, in case of Multi factory traditional cost systems will not be effective and accurate. For Single factory, finance manager can simply divide total expenses by total production volume to get the cost per pen whereas in Multi factory, the indirect and support expenses would be traced to its various production centres and once these expenses are accumulated, they would be applied to products based on the cost driver for that cost center.

Therefore, Multi factory’s overhead costs would be applied to products proportional to their production volume.

Organizational spending on resources

Activities and business performed by resources

ABC system

Cost of indirect and support expenses on various activities

Activity cost driver for various activities

Products/ services/ customers

Direct costing systems fail to explain why two factories with exactly same physical units of production have such huge difference in levels of fixed costs. This can be well explained by assignment of support resource costs. Activity-based cost systems therefore extend traditional cost systems by linking resource expenses to the variety and complexity of products produced and do not just depend upon the volume of production.

An ABC cost system explains the following:

Need For Spending On Indirect And Support Resources:

The spending on indirect and support resources is required because of the activities performed (eg. Scheduling, purchasing, improving products etc.) or the capabilities supplied by these resources. this explains the need for organizational spending. An organization will therefore:

Identify the set of activities being performed by its indirect and support resources. Culminate the identification of these activities in construction of activity dictionary that lists and

defines major activities performed in production centres. ABC team then ignores activities that use less than 5% of an individual’s time or a resources

capacity An activity dictionary of about 10-30 activities is prepared where focus of the ABC system is to

estimate product and customer costs. Detailed activity dictionary is prepared for process improvement and redesign efforts.

Amount Of Spending By An Organization On Each Activity:

The abc system maps from resource expenses to activities using resource cost drivers. These resource-cost drivers link spending and expenses as explained in organization’s ledger systems, to the activities performed.

Data from organization’s financial system categorizes expenses by spending code. The resource cost drivers collect these expenses and drive them to the activities being

performed. For non-personnel resources, the ABC team relies on direct measurement or estimates the

percentage of the resource used by each activity in the dictionary. This system drives operating expenses to activities that are not directly involved like setup

machines, schedule production runs.

financialFinancial

General

Data collected to determine activities

being performed

Cost of each activity calculated

ledger

Resource cost drivers

ABC system

This gives an insight into how much an organization spends on activities such as purchase of materials, introduction of new products, new setup. The actual mechanics of selecting resource cost drivers and estimating their quantity are documented in books that describe the details of implementing ABC systems.

Hierarchy of activities:

Unit-level activities: These activities are performed for every unit of product or service produced. The quantity of unit-level activities performed is proportional to production and sales volumes.

Major difference between activity-based and traditional cost systems is the use of non-unit cost drivers for assigning resource costs to products and customers.

Batch-level activities: These are activities performed for each batch or setup of work performed that include setting up of machine, purchasing of materials etc.

Resource required for these activities are independent of the number of units in the batch.

ABC systems measure and assign the cost of handling production orders, material movement, setups, customer orders etc.

Product-sustaining activities: They are performed to enable production of individual products. Extending this notion outside the factory leads to customer-sustaining activities that enable selling to individual customer but are independent of volumes produced. Eg: maintaining and updating product specifications, special testing and tooling for individual products.

The ABC cost hierarchy helps and enables all organizational expenses to be mapped to a level where cause and effect model can be established.

If we refer to the example of Single and Multi factory, both have the same physical output of volume. They may also have same level of facility-sustaining expenses but there will be vast difference in the expenses incurred due to batch-level activities as a Multi factory will require far more resources to perform additional batch-level activities required by the different products it manufactures.

Therefore, at the end of second phase of building an ABC model, the organization knows expenses characterized by activities performed.

Need For Performing Activities By An Organization:

An organization performs activity to design, build and deliver products and services to its customers. Therefore, and ABC project team identifies all the organization’s products, services and customers. Whether an organization is compensated for performing these activities requires that activity costs be linked to the products, services and customers (the ultimate beneficiaries of an organization’s activities).

Amount Of Each Activity Required For Organization’s Product, Services, Customers:

The linkage between activities and cost objects, such as product, services and customers, is accomplished using activity cost drivers.

An activity cost driver is a quantitative measure of the output of an activity.

Types Of Activity Cost Drivers And Their Selection:

Because of the large number of potential activity-to-output linkage, the ABC project team attempts to economize on the number of different activity cost drivers. Activities that are triggered by the same event can use same activity cost driver.

ABC system designers can choose from three different types of activity cost drivers:

1. Transaction2. Duration3. Intensity or direct charging

Transaction drivers like number of setups, number of receipts and number of products supported, count how often an activity is performed. These can be used when all outputs make same demand on the activity.

Least expensive type of drivers. Could be least accurate as they assume that same quantity of resource is required each time an

activity is performed.

Duration drivers, such as setup hours, inspections hours and direct labor hours, represent the amount of time required to perform an activity. They should be used when significant variation exists in amount of activity required for different outputs.

More accurate than transaction drivers. More expensive to implement since model requires an estimate of duration each time an

activity is performed.

Intensity drivers directly charge for resources that are used when an activity is performed. Duration drivers typically assume that all hours are of equal cost but use of extra personnel, especially skilled personnel may shoot up the cost of an activity thereby increasing the cost of the output. This consideration is done by choosing intensity drivers.

Most expensive to implement. Require direct charging via a job order costing system to keep track of all resources used each

time an activity is performed. Should only be used when resource used for any activity are expensive and variable each time

an activity is performed.

Activity cost drivers, though the most important innovation of ABC system, are the most costly aspect of

this system.

If an organization requires different activities for 5000 individual products and customers, (assuming 500 activities are used), an analyst would have to enter 2,50,000 pieces of information. This is why an ABC system for products and customers purposes, limit their entries 30-50 different activity cost drivers.

Application Of Activity-Based Cost System:

Two simple rules help to guide the search for potential ABC application:

1. The Willie Sutton rule: this rule looks for areas with large expenses in indirect and support resources. if organizational activities are all at the unit level, the ABC system and traditional costing system will yield very similar result. Operations where direct labor and direct materials are involved may have less need for ABC systems.

2. High diversity: a situation where large variety of products, customers or processes is involved will require an ABC system. This rule is violated by Single factory where the total manufacturing expenses involved when divided by the volume of products produced gives the cost per unit and therefore investing in ABC system is not required whereas in a Multi factory where different products require different manufacturing expenses, an ABC system of cost calculation will be efficient.

In some organizations, where product costing is not a major concern, ABC model gives an insight into the underlying process costs.

An ABC system may be lowest cost system yet it may not be the most accurate one. One should take note of the following:

The goal of ABC system is not to have the most accurate cost system. It should be a relatively simple system with perhaps 30-50 activities using mostly transaction

drivers for the calculation of activity and process costs to 5% to 10% accuracy. A properly constructed ABC model should represent an economic model of an organization’s

expenses. For companies operating in stable environments, with mature products, a traditional costing

system is fine to guide operations. For a company that is manufacturing new products, introducing new processes, reaching new

customers, as it operates in new environment, an ABC system with an economic map of their operations will be beneficial. This will reveal their cost of activities and business processes leading to knowledge of the cost and profitability of individual products. Customers and operating units.

An ABC system produce good estimates of the quantities and the unit costs of the activities and resources deployed for individual products, services, customers.