Activity Based Costing (ABC) is one of a number of possible costing methodologies utilised in organisations. It identifies activity centres in an organisation, and assigns costs to product or service units based on the number of activities or some form of utilisation metric used by each product or service unit. ABC ascertains the purpose of each activity or service and assigns the cost of such activity or service to the product or service unit that has made use of such activity. ABC may be considered to be a more precise costing tool in comparison to absorption costing, which is based on the principle of absorbing the cost of a finished unit in inventory or of a service as the sum of the cost of direct materials, wages of direct labour, and both variable and fixed overheads.
ABC clearly delineates all the direct costs and the exact proportion of overheads that are being ascribed to the production of a particular unit of output or a particular discrete output. By way of example, a mass-produced food item like, say a beef burger, can use the same amount of labour and materials as a customised beef burger for a specific client. The customised burger uses far more of the food technologist’s time (an overhead) to develop the right recipe and the components therefor, than does the traditional, mass-produced burger. In essence, ABC tells us with a degree of precision which individual products or services are profit-making and which ones are loss-making, as well as the degree to which they are. Most organisations have traditionally used an absorption method, possibly because it is acceptable for external and auditing purposes and it definitely is a more straightforward approach. However, as competitive pressures mount on organisations, it has become key to utilise ABC and determine which products and/or services to keep or cut, what is generating profits and what is not.
ABC therefore identifies the in/efficiencies that lie in products, within departments and/or activities. This enables the allocation of organisational resources on those areas that are more profitable. ABC is also a flexible model, yielding both a holistic overview of organisational cost structure as well as costs related to each product, department and/or activity. Thus, it helps identify unnecessary costs that can be eliminated far more easily, and enables a superior cost control mechanism. Another advantage of ABC lies in the possibility to give a precise cost estimation, which helps when it comes to fixing and determining the optimal pricing of a product or service with any desired analytical resolution. The only criticism that may be levelled at ABC is the academic nature it takes on where there are no clear ways of identifying a cost-driver with a cost unit.
At Equinox Advisory the following are the steps we normally take to implement an ABC system.
Define the specific objectives of the project and whether ABC is the right system to attain those objectives;
- Determine whether the ABC method is viable with current organisational setup and data-capturing systems in place;
- Identify any business process re-engineering that might be needed to fill in any existing data gaps;
- Establish any training requirements employees at all levels that needs to take place for the system to work well;
- Identify business activities and cost drivers;
- Map the whole operational flow of the organisation and determine how resources and activities are related to products and services;
- Implement systems for the capturing, collection and storage of cost-related data at each operational stage;
- Analyse the data collected at predetermined time intervals;
- Preparation of reports, including results, conclusions and recommendations at regular intervals.
At Equinox Advisory, we have a wealth of experience in developing the technique of ABC in both service sectors and product manufacturing. We are also aware that the majority of organisations tend to abandon their intention to implement ABC. It may not be as easy as ‘abc’, particularly because it involves understanding the organisation in a radically different way. Therefore, our experience has shown that ABC must first be accepted as being an organisational change program that will affect people across the company from senior management to front liners.
This is specifically why we also give our clients the option to engage personnel with a knowledge of organisational psychology on ABC projects, giving a psychological insight of the potential obstacles that may lie ahead, educating and training the people first to accept this new way of working prior to undertaking the required changes. Sometimes, we have also been asked to measure the impact of ABC on the organisation and its work practices. Apart from the more obvious financial performance metrics, we have adopted a balanced scorecard approach to measure the overall organisational development and performance including the performance of individuals and how ABC has enhanced employee’s understanding of the business and its alignment with the firm’s strategic objectives. A ‘balanced’ view of organisational performance gives employees, particularly management, a better overall perspective, including performance measures related to internal processes, individual and corporate self-improvement, customer focus and satisfaction and, of course, financial performance.