A Review of Activity Based Cost Management Principles

What is Activity Based Costing?

It is a means of identifying the resources - money, people, assets - consumed by each activity that is performed in an enterprise. It identifies the events or drivers that cause each activity to be performed. These drivers and their relationship to products, services and customers are used to assess product, service and customer cost and profitability.

ENTERPRISE

PERFORMANCE

OPTIMIZATION

Definitions
Definition Function
An area of related skills supporting one area in the business A series of related tasks carried out repeatedly An event or factor which causes an activity to be performed A series of activities required to achieve an outcome

Example
Accounts Receivable

Activity Driver

Chase a customer for late payment Unpaid Invoices

Process

Invoicing Process

ENTERPRISE

PERFORMANCE

OPTIMIZATION

Traditional (Standard) Costing

Direct Labour Machine Time Direct Cost Ratio Floor Area etc., etc.

Indirect costs

Standard costing fails to apply cost in the way it is really incurred! It produces a result that is precisely wrong

Customer, Product or Service costs

OPTIMIZATION

ENTERPRISE

PERFORMANCE

Activity Based Costing

Activity 1 Activity 1 Activity 1 Activity 1 Activity 1 Activity 1

Activities and their drivers create a meaningful link between products, customers, and the resources they each consume.

Cost Driver 1 Cost Driver 1 Cost Driver 1 Cost Driver 1 Cost Driver 1 Cost Driver X

Customer A Customer A Customer A Customer A Customer A Customer A

Product 1 Product 1 Product 1 Product 1 Product 1 Product 1

ENTERPRISE

PERFORMANCE

OPTIMIZATION

Example of Activity Drivers

Customer A 18K gross margin ABC cost of debt chasing: 250,000 Number of debt chases: 1000 Customer B 20K gross margin

0 debt chases
0 incurred cost 18K adjusted margin

Average unit driver cost: 250/chase

12 debt chases
3K incurred cost 17K adjusted margin

ENTERPRISE

PERFORMANCE

OPTIMIZATION

Example of Activity Drivers

Activity driven by a Customer Order
Receive customer order Validate customer order Input order to system Produce order confirmation Schedule order Produce picking documents Pick order in warehouse Pack order Produce despatch documents Despatch and deliver order Produce and mail invoice Receive payment Customer A Margin 100K Monthly Order 12 orders/year Customer B Margin 120K Weekly Order 52 orders/year

Do these customers cost the same to deal with ?

OPTIMIZATION

ENTERPRISE

PERFORMANCE

Assigning Base Costs to Activities

Activity related costs are assigned to individual activities on the basis of rational allocation methods

Costs

from chart of accounts

Activity-specific costs
Allocation methods

For example:

Activity Analysis

Employment costs: Hours worked per activity or %age of time spent Occupancy costs: Square or cubic meters (or feet) Network costs: Log-on time, Processing time etc.
ENTERPRISE PERFORMANCE OPTIMIZATION

Flow of Costs
Costs

Activity Analysis
Allocation Methods Allocation Methods

Allocation Methods

Activity driven by products, services & customers

Activity directly driven by front-line delivery

Internal support activity

e.g., Personnel, IT, Office services

Sustaining activity with no link

e.g., Management accounting, Strategy development, Corporate planning

ENTERPRISE

PERFORMANCE

OPTIMIZATION

Flow of Costs
Costs

Activity Analysis
Allocation Methods Allocation Methods

Allocation Methods

Activity driven by products, services & customers

# Driver

Internal support activity

Sustaining activity with no link

Products Services Customers

Activity costs taken to products,services, customers using the driver volume of each activity by service or customer
PERFORMANCE

Sustaining cost

ENTERPRISE

OPTIMIZATION

Some Examples of Drivers

# # # # # # # # # # # # # # # of of of of of of of of of of of of of of of domestic customers export customers orders placed orderlines - domestic orderlines - export machine set-ups production defects schedules placed units processed new products introduced supplier late deliveries schedule changes supplier defects order lines - goods In inspections # of cash payments in # of new accounts set-up # of account closures # of customer claims made # of refunds # of invoices processed # of customer returns # of customer enquiries # of customer complaints # of telephone calls received # of policies issued # of cheques processed # of direct debits # of late payments # of terminals connected

ENTERPRISE

PERFORMANCE

OPTIMIZATION

Costs Not Related to Activities

From chart of accounts

Costs

Product, customer, service or channel specific costs

Activity specific costs

Non-specific costs

Some costs might relate to specific customers or services and not be related to activity... e.g. raw materials
ENTERPRISE PERFORMANCE

Other costs may have no reasonable direct relationship to activities, products or customers... e.g. changing the corporate logo

OPTIMIZATION

Final Flowchart of Costs

From chart of accounts

Costs

Product, customer, service or channel specific costs

Drivers or %age allocations

Activity specific costs

Drivers or %age allocations

Non-specific costs

Activity analysis

Customers Services Products

Drivers or %age allocations

Unabsorbed cost
OPTIMIZATION

ENTERPRISE

PERFORMANCE

Profit and Loss from a Different Perspective

Revenue from Customers/Products

less

Service/Product Driven Costs Customer Driven Costs Channel/Distribution Driven Costs

ABC Contribution

less

True Sustaining Unabsorbed Overhead Costs Profit (or Loss)

ENTERPRISE PERFORMANCE OPTIMIZATION