Concept of Activity-Based-Costing: Activity Based Costing (ABC) is an accounting technique

that allows an organization to determine the actual cost associated with each product and service
produced by the organization without regard to the organizational structure. It is developed to
provide more-accurate ways of assigning the costs of indirect and support resources to activities,
business processes, products, services, and customers. ABC systems recognize that many
organizational resources are required not for physical production of units of product but to
provide a broad array of support activities that enable a variety of products and services to be
produced for a diverse group of customers. The goal of ABC is not to allocate common costs to
products. The goal is to measure and then price out all the resources used for activities that
support the production and delivery of products and services to customers.

An organization performs activities to do its business. These activities define the kind of
business they are in: an accounting firm prepares tax returns; a manufacturer produces products;
a council delivers services; a university teaches students. All activities consume resources. It is
the consumption of these resources that adds to overhead costs.

The basis of Activity Based Costing is to look at the activities required to produce the cost of the
product or service. The activities consume resources and the cost of these can be calculated. The
amount of activity required for each product and service is determined, hence the real cost can be
determined.

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more
logical manner than the traditional approach of simply allocating costs on the basis of machine
hours. Activity based costing first assigns costs to the activities that are the real cause of the
overhead. It then assigns the cost of those activities only to the products that are actually
demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same
company. Product ‘X’ is a low volume item which requires certain activities such as special
engineering, additional testing, and many machine setups because it is ordered in small
quantities. A similar product, Product ‘Y’ , is a high volume product—running continuously—
and requires little attention and no special activities. If this company used traditional costing, it
might allocate or "spread" all of its overhead to products based on the number of machine hours.
This will result in little overhead cost allocated to Product ‘X’ , because it did not have many
machine hours. However, it did demand lots of engineering, testing, and setup activities. In
contrast, Product ‘Y’ will be allocated an enormous amount of overhead (due to all those
machine hours), but it demanded little overhead activity. The result will be a miscalculation of
each product's true cost of manufacturing overhead. Activity based costing will overcome this
shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups,
and others are activities that cause costs—they cause the company to consume resources. Under
ABC, the company will calculate the cost of the resources used in each of these activities. Next,
the cost of each of these activities will be assigned only to the products that demanded the
activities. In our example, Product ‘X’ will be assigned some of the company's costs of special
engineering, special testing, and machine setup. Other products that use any of these activities
will also be assigned some of their costs. Product ‘Y’ will not be assigned any cost of special
engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because

(1) manufacturing overhead costs have increased significantly,
(2) the manufacturing overhead costs no longer correlate with the productive machine hours or
direct labor hours,
(3) the diversity of products and the diversity in customers' demands have grown, and
(4) some products are produced in large batches, while others are produced in small batches.

While traditional costing arbitrarily allocates overhead costs, ABC traces overhead costs by
looking at the activities that each product and service calls upon. With ABC the products
consume the activities. It is the activities that cost money.

If there were no activities, no resources would be consumed. It is the activities that you do
that define your business.

Why use Activity-Based-Costing?

Activity-Based-Costing is necessary for the following reasons.

* Understand TRUE profitability of any customer transaction, products, or services

* Quantify the cost of non-value added activities such as errors and reworks

* Identify opportunities to reduce costs and/or increase efficiency

* Obtain actionable information to negotiate price increases for unprofitable clients

* Understand why profitability may be mediocre despite good strategic fundamentals

* Stratify overhead costs so they can be managed more effectively

How Does ABC Work?

The first stage in an initial ABC study is to develop a fundamental understanding of the
Resources (expenditures) and Activities (work performed) of an organization. The Resources are
then mapped to the Activities, thereby quantifying the cost of performing each of these
Activities. These costs are traced to Cost Objects (customers, products, or services) providing
tremendous insight into where an organization is making and losing money.
ABC Model:

The objective of an ABC implementation is to relate all of the costs of doing business to
products, services, or customers. Developing the initial model consists of the following five
steps:

1. Identify the Resources (expenditures) of an organization

2. Determine Activities (work performed) that are supported by Resources

3. Define Cost Objects (products, services, customers)

4. Develop Resource Drivers to link Resources to Activities

5. Develop Cost Drivers to link Activities to Cost Objects

Evaluation of ABC method:

Today, companies are using ABC to make better-informed decisions about pricing, what type of
customers to pursue, and what products or services to offer. Activity-Based Costing determines
the TRUE COST & PROFITABILITY of customers, products, and/or services. While traditional
accounting may provide business with an accurate sense of the direct costs of your products or
services, indirect costs are often less accurately applied. Overhead, such as customer support or
marketing costs, tend to be allocated based on arbitrary factors.

Activity-Based Costing measures the costs and profits of an organization based on the activities
performed within that organization. By focusing on processes that contribute to revenues and
business operations, ABC can accurately determine how each process relates back to specific
products, customers, or services. This can make a big difference after considering warehouse,
sales, customer service, administration and other costs that are often applied at a standard rate.