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How can companies use activity-based costing to make more informed decisions?

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Activity-based costing (ABC) is a method of allocating overhead costs to products or services based on the activities they consume. Unlike traditional costing, which assigns costs based on a single factor such as labor hours or machine hours, ABC recognizes that different products or services may require different levels and types of resources. By using ABC, companies can gain more accurate insights into the profitability and performance of their products or services, and make more informed decisions about pricing, budgeting, outsourcing, and process improvement.

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Ramaswamy V Krishnamurti

ERP Enterprise Architect and Business Advisor

1 Benefits of ABC

ABC can help companies improve their decision making by providing more relevant and reliable information about their costs and profits. It can reveal the true cost drivers and value-added activities of each product or service, helping to identify and eliminate waste, inefficiency, and non-value-added activities. Companies can also set more competitive and profitable prices based on the actual cost of each product or service, rather than using an average or arbitrary markup. Additionally, ABC can help allocate resources more effectively and efficiently, as well as prioritize the products or services that generate the most value for customers and the company. Lastly, it can evaluate the performance of business units, departments, processes, and employees based on the activities they perform and the value they create.

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Ramaswamy V Krishnamurti

ERP Enterprise Architect and Business Advisor
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Traditionally indirect costs and overheads are allocated proportionately based on units like machine hours, labour hours etc. This overstates the cost of some products and understates that of others. Unlike this, ABC identifies the activities that lead to those Overheads and calculates the rate per activity unit. By identifying the number of activity units consumed per product, we can more accurately allocate the costs to these products. As can be seen, this method useful when widely different number of activity units are consumed for each products. First step is to validate this for the customer. ABC is tough to implement, traditional ERPs work on proportionate allocation methods and are not designed to handle ABC.

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2 Steps to implement ABC

Implementing ABC requires a systematic and detailed analysis of the activities and costs associated with producing or delivering a product or service. To do this, the first step is to identify the main activities and outputs of the company and group them into activity pools. For example, a manufacturing company may have activity pools such as purchasing, production, quality control, packaging, and shipping. These activity pools then have overhead costs assigned to them based on the resources they consume. Additionally, cost drivers need to be determined for each activity pool - these are factors that cause or influence the level of activity and cost. The activity rate for each activity pool is then calculated by dividing the total cost of the pool by the total amount of the cost driver. Finally, the costs of each activity pool are assigned to products or services based on the amount of the cost driver they use.

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S Vijay Venkatesh

Co-founder & MD @ Syscon Cronus - ERP | No-nonsense Mfg ERP | ERP Success & Turnaround specialist | Eat, Breath and Sleep ERP | Yoga practitioner
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To choose an ERP system that has the full fledged configuration of Cost of Goods Manufactured (COGM) and Cost of Goods Sold (COGS). This configuration has 2 distinct advantages. 1. Any manufacturing has 2 cost components. A. Material consumed B. Process cost (labour + Machine + other direct overheads) We need the BOM to allow definition of the standard details of A & B as well as the Route card / Batch process to allow modifications if any to capture the actuals. With this COGM can be arrived. 2. COGS will actually update all inventory movements via JVs into the accountind module automatically. Only when the Sales is booked under revenues, the COGS is charged off to Expenditure automatically. So P&L and BS can be viewed any time.

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3 Challenges of ABC

ABC can provide more accurate and useful information for decision making, but it also has some challenges and limitations. For instance, collecting and analyzing the data required for ABC can be time-consuming and costly, especially for complex businesses with multiple products or services. Additionally, it can be challenging to identify and measure the appropriate cost drivers and activity pools, and to allocate the overhead costs accurately. Furthermore, frequent updates may be needed to reflect changes in the business environment, customer preferences, and competitive pressures. Finally, ABC can create confusion and resistance among those accustomed to traditional costing methods and performance measures.

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4 Best practices for ABC

ABC can be a powerful tool for decision making, but planning, execution, and evaluation must be done with care. To ensure success, it is important to align the ABC system with the strategic goals and objectives of the company and communicate the benefits and expectations of ABC to stakeholders. Additionally, it is beneficial to start with a pilot project or small scope of the business to test and refine the ABC system before expanding it. A cross-functional team should be used to involve experts and users in the design, implementation, and review of the ABC system. Furthermore, integrating the ABC system with existing accounting and information systems, as well as automating and simplifying data collection and analysis processes through software and technology is essential. Lastly, monitoring and evaluating the ABC system regularly, as well as updating and adjusting it as needed to maintain accuracy, relevance, and usefulness should be done.

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5 Examples of ABC

ABC can be applied to various industries and sectors, such as manufacturing, service, health care, education, and public administration. For instance, a hotel can use ABC to allocate costs of facilities, staff, and services to different types of guests. This helps the hotel determine profitability and customer satisfaction of each segment, allowing them to optimize pricing, marketing, and service strategies. Similarly, a software company can use ABC to allocate costs of development, testing, maintenance, and support activities to different types of software products. This helps the company identify the most profitable and competitive products and allocate resources accordingly. Additionally, a hospital can use ABC to allocate costs of medical, administrative, and overhead activities to different types of patients, procedures, and departments. This allows the hospital to measure cost-effectiveness and quality of its health care services while improving operational efficiency and patient outcomes.

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?? Bruno Oliveira, MBA FMVA? CertIFR

CFO ???? at Swissport | Strategy | FP&A | Leading Finance Transformation | Lean Finance | Operational Excellance | International Speaker | C-Level
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Una vez quando trabalhava em um banco, participei de um projeto de custeio ABC para medi??o de custos de servi?os financeiros. A contagem de tempo, análise de complexidade das atividades, análise do fluxo e também busca de oportunidades de melhora de eficiência s?o essenciais para o sucesso de um projeto de custeio ABC.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can companies use activity-based costing to make more informed decisions?

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1 Benefits of ABC

2 Steps to implement ABC

3 Challenges of ABC

4 Best practices for ABC

5 Examples of ABC

6 Here’s what else to consider

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