The essence of Activity-based Costing (ABC) is the idea that businesses are "activity-driven." ABC determines the costs of these activities and shows how these activities affect the cost dynamics in a business. Activity-based information can be used for a variety of purposes.
ABC provides information that enables managers to monitor the cost usage and emphasises the areas of high cost on which attention should be focused. It provides a tool with which the cost/ benefit associated with investment in new products, markets, technology etc. can be measured and alternative investments prioritised in terms of value for money and impact on corporate performance. It also enables management to highlight areas within the institution that utilise excessive amounts of resource.
Strategic Cost Analysis
ABC can help in prioritising business activities, because it can provide information relating to the cost/benefit to be derived from the particular businesses, geographic markets, products or customer groups and the potential benefit to be derived from future investment in particular strategic direction.
Reasons for performing ABC for strategic cost management may include the need to review the overall direction of the company as the result of a merger, acquisition or take-over. It may be part of a strategic planning exercise or may simply be necessary as a major investment or divestment decision is to be made. It is unlikely to be performed more than once each year. A regular ABC system can also be used to provide consistent information for cost/benefit evaluations.
ABC can form the basis of a Value-based Management system, which may incorporate Activity-based budgeting and use activity analysis as a means of measuring and monitoring the cost, volume, value and quality of business processes. It leads to a better understanding of cost/resource management, emphasising the lag between spending and consumption, by analysing the factors that cause the initial expenditure and monitoring the consumption of resources and capacity utilisation.
Activity-based information can be important in assisting management to gain a better understanding of the use of the human resources within the organisation. The classification of activities into those that are product and customer facing and those that sustain the corporate infrastructure enables management to evaluate the amount of effort invested in the various business processes within the organisation and to target areas for improvement. It will provide the necessary information for bench-marking and for the quantification of any improvements in the time or cost associated with the activities performed.
Product costing is the most common use of Activity-based information and often forms the basis for product pricing and product profitability analysis. Activity-based Cost analysis encourages organisations to extend existing cost analysis to review the underlying cost drivers in relation to the basic business processes and therefore gain a greater understanding of cost dynamics.
It can also be used in new product development to estimate the approximate cost of product delivery in advance of the product launch.
The cost of providing the mix of products and services to a customer or type of customer is usually based on a mix of transactions and products cost information, but may be enhanced to include those costs (such as relationship management) that can be attributed directly to individual customers or customer groups.
It can be difficult to justify the cost of developing and maintaining customer profitability information for individual customers as this involves the capture and storage of individual transaction analysis from all automated and manual systems within the organisation, as well as the maintenance of up-to-date customer profiles. The value given to this information depends, to a large extent, on how it will be used and this generally reflects the importance of the individual customer relationship to the company.
Operational Cost Management
Operational cost management including such techniques as Six-Sigma, Kaizen, Business Process Re-engineering, Total Quality Management, Just in Time and Continuous Improvement, relies on a good understanding of the activities and processes within the organisation.
Quality can be improved through a greater understanding of customer needs and the value adding and non-value adding activities within each process. Efficiency can be improved by eliminating duplication and unnecessary activities, improving work-flows and training staff. Effectiveness is dependent on undertaking the right activities, efficiently. By attributing costs to the activities, management can prioritise areas where effort should be focused to enable working practices to be made both more efficient and more effective and where costs could be reduced or performance improved.
Activity Based Budgeting
Activity-based budgeting separates the analysis of cost/benefit and value of activities from the more mechanistic budgeting exercise, reducing the complexity of the budgetary process and concentrating attention on the management of the business, not simply the costs incurred.
It enables activities to be classified under two main headings: those costs that are incurred to sustain the basic fabric of the organisation and those costs that are driven by the levels of underlying business activity in some way. Sustaining costs may be analysed purely to ensure that the activities are both efficient and effective. The business-related costs, on the other hand, must be reviewed in relation to the factors that drive the costs and managed to ensure that spending remains in line with consumption, both in terms of the volume of activity and the quality of service provided.
Performance management combines objective setting, cost control and responsibility by setting people related targets or key performance indicators and monitoring activity against the indicators on a regular basis. Performance can be influenced by using these key performance indicators as the basis of regular reporting, identifying those areas where individual managers can control or influence behaviour towards the achievement of corporate objectives. ABC can provide a consistent source of much of the activity and cost related information on which the key performance indicators are based.
Cost reduction initiatives
Cost reduction initiatives involve employing the Activity-based Costing approach to analyse the activities performed throughout the organisation and using this analysis as the basis for cost/benefit evaluation of the functions under review. The results of this exercise can then be used to identify areas where the benefits derived do not justify the costs incurred and hence where activities may be curtailed or eliminated.
The primary benefit of using ABC rather than any other form of costing lies in the essence of the technique itself. Activity-based information focuses on activities not responsibilities and can therefore be less threatening to the managers of the various functions under review. It depersonalises the cost review and enables management to value the activities undertaken in relation to the level and/or quality of service provided and the factors that cause costs to be incurred.