Question

Activity Based Costs (ABC) what is it and how does it impact profitability?

Answer 1

Activity Based Costs (ABC) what is it and how does it impact profitability?

What is activity based costs (ABC)?

Traditionally, costs are the amount of money required to manufacture or produce something. There are two types of costs – direct costs which can be directly attributed to the product (viz. costs of raw material and labor). The other type of costs are called indirect costs which cannot be directly a attributable to the product (like rent and telephone). The profitability is derived by difference between the sales price and sum total of costs. The biggest drawback of traditional costing is its inability to allocate indirect costs correctly to the product. As these costs are absorbed arbitrarily, the actual real cost is never known and thereby profitability calculations go wrong. In spite of this problem, costing is still done in the traditional way because this method is widely accepted by most governments, tax authorities and stock markets for valuation.

Activity based costs is another method of costing proposed in order to get better idea of impact of costs on profitability. This method also called ABC method is practiced since 1950’s by many organizations but it was never considered to be the main method of costing. In 1980, Kaplan and Bruns and in 1990s Robin Coper studied the activity based costs systematically and published results. Their study clearly highlighted the lacunae of the traditional costing and suggested the activity based costs model.

Activity based costing considers organizational processes and activities to make products. Examples are designing products, setting up machines, manufacturing products, etc. Each of these activities demand resources from the organization. Now, when the organization deploys resources to conduct a specific activity, it incurs costs. The sum total of all such costs of deployed resources to conduct all activities to make and sale a product is the activity based cost of that product.

The activity is further classified into five broad levels – batch, unit, customer, organization and product. So, setting up machine is batch level activity. Assembly of finished product is unit level activity. Sales is customer level activity. Payroll and administration are organizational level activities. Pricing and packaging are product level activities.

Each of these levels are measured under two categories – volume, i.e. how many times the activity will occur and time or duration of the activity. Examples are how many times the machines are setup – it may be once in a week. Also time taken to setup machines may be four man hours. So in a month, this activity will take place four times with sixteen man hours of overheads.

Activity based costs are derived using following process:

1. Identify and list activities
2. Determine level of each activity – one of the batch, unit, customer, organization and product.
3. Determine volume and period of each of the activities.
4. Estimate costs of each activity based on levels, volume and period.
5. Aggregate the costs of all activities to create a product using bottoms-up approach to arrive at the activity based costs.

How activity based costs (ABC) impact profitability?

Activity based costs correctly derive the cost of the product more accurately compared to traditional costing. Once the correct costs are known, it helps organizations to determine profitability by setting appropriate selling price.

Activity based costs determine costs at all activity levels which gives a much better understanding of the granular level costs in making of the product. This detailing helps organization take better decisions of the activities where the costs can be reduced thereby improving profitability. Without this tool, organizations are actually blind with lack of information and their decisions may go wrong.

In activity based costing, the activities are determined and then resources allocated thereby consuming costs, this gives clear picture of allocated resources to create products. Here organization can determine correct number of resources and quality of resources and duration of resources – this all leads to reduction of costs and improving profitability.

Activity based costing provide granular level costs information to managers – they can look at the costs from multiple dimensions, which enables them to conduct multiple permutations and combinations of allocation of resources to activities. The best mix provides maximum profits.

The examples of impact of ABC on profitability are given below:

1. ABC may reveal that the R&D activities are not adding much value and so the R&D resources can be reduced by 50% thereby saving costs and improving profits.
2. ABC may reveal that the duration of finished goods lying in warehouse is one month which can be reduced to few days thereby saving in carrying costs and improving profitability.
3. ABC may reveal the two separate operations on the product – say drilling holes and bending can be done by same resource thereby reducing resources and costs thereby improving profitability.
4. ABC analysis can present various possibilities by permutation and combinations of conducting multiple activities – this helps in planning so as to maximize profitability.
5. ABC can present costs on all five dimensions - batch, unit, customer, organization and product. This can help organization decide where to spend more and where to cut costs.
6. ABC can also help in better pricing decisions. Better pricing means more sale at higher profitability.