Activity-Based Costing (#266)
/In this podcast episode, we discuss activity-based costing. Key points made are noted below.
Overview of Activity-Based Costing
As the name implies, this is the concept of tracing costs to specific activities within a business. Now, why would you do that? Consider that a business normally tracks its costs at the level of expense type, such as rent expense, or utilities expense, or compensation expense. When you’re trying to improve the performance of a business, just looking at an income statement with these expenses listed on it doesn’t really provide you with any information about how the business actually operates. So, if you decide to arbitrarily decrease one of these expenses, such as compensation, you really don’t know what impact that will have on the business.
But if the existing system for tracking expenses doesn’t give us much actionable information, then why do we use it? The main reason is that the typical accounting system is designed to accumulate data as quickly and easily as possible, in order to produce financial statements. The emphasis is on doing accounting at the lowest possible cost.
This is where ABC comes in. The emphasis is entirely on producing actionable information, where you can tell how much it costs to engage in any of a large number of activities within a business. And there can be hundreds of activities, such as making sales calls, or processing customer orders, or scheduling production jobs, or maintaining equipment, or training employees. Or, just within the accounting department, examples of activities are issuing customer invoices, processing cash receipts, and processing supplier invoices.
The Effort Needed for an ABC System
If you really want to accumulate the cost of each of these activities, the cost is monumental, because there has to be a tracking system for each one. For example, just tracking the cost of the sales call activity means having everyone in the sales department start logging their hours associated with sales calls, plus travel expenditures just for this specific activity. If you were to expand this level of activity tracking to every significant activity within a business, you could be looking at expanding the administrative work within a company by many multiples. Which is why you don’t hear about a whole lot of successful ABC installations. Someone in management gets enthusiastic about the concept and tries to roll out a company-wide system, which could take years. Because setting up the data collection systems takes so long, pretty much everyone gets frustrated with the project, and it gets dropped before it ever has a chance to produce any information that management can use.
How to Make an ABC Project Succeed
This does not mean that ABC is a bad idea. Far from it. You just have to be careful to target it very specifically, so that the existing data collection systems don’t have to be adjusted all that much, and in a way that doesn’t interfere with the normal work of employees. That means a successful ABC project might only involve a couple of extra data collection activities.
To make the project even more likely to succeed, it should be initially set up as a short-term project, where there’s data collection, and a final report that summarizes cost information – and that’s it. The data collection is then stopped and the project ends. By doing it this way, ABC is not considered to be a long-term administrative burden on the company. Instead, it’s expected to last just a few months, which most people will find tolerable. For example, management might want to look at which customers are taking up too much activity to be profitable, so the cost accountant tracks customer usage of activities like the processing of returned goods, the processing of bad debts, and customer service calls. And after that she delivers a final report that identifies a list of customers that should either be dropped or have their prices increased. The company may not need to revisit this topic for another five or ten years, so the project is terminated.
That does not mean that every ABC project has a short life. If management finds that the results from a particular project is giving it actionable information over a long period of time, then the data collection systems associated with it need to be made permanent, which means installing some automated data collection systems, and adding formal procedures and revising job descriptions to embed the process into the company. But this is rare. You can expect that if a company runs 20 ABC projects, maybe one of them will end up being part of the permanent systems of the organization.
Cost Object Analysis
So, moving along – management has targeted a focused project area, and there’s a cost accountant collecting data about the cost of activities. Now what? This is where the concept of a cost object comes in. A cost object is any item for which a cost is compiled. There’re lots of cost objects in a business, such as products and services, one-time projects, distribution channels, sales regions, and customers.
Ultimately, the whole point of an ABC project is to figure out how much each cost object is costing the business, so a request from management will probably not be to figure out, for example, the cost of each customer service call – which is an activity. A more likely management request is to figure out the total cost of each customer, of which customer service calls are only a small part. Therefore, the cost accountant receives a request from management to determine the amount of a cost object, and then determines which activities need to be tracked, so that the cost of these activities can be traced back to the cost object.
Data Collection Activities
This means that yet more data collection needs to be performed, to determine activity usage by cost objects. For example, the cost of a manufactured product includes ten minutes of machining at a computerized lathe. The cost accountant has to track a bunch of things to arrive at the cost of the activity, which is machining time, and then has to track the amount of time required to run the product through that activity. Only after both steps have been taken can we arrive at the final cost assignment for the product, which is the cost object.
Project Setup Decisions
When setting up one of these ABC projects, the cost accountant needs to make a few additional decisions, which could make the project either more or less complex. When making these decisions, the accountant has to balance the additional amount of work required against how valuable the incremental improvement in information will be.
For example, the accountant needs to decide how many activities to track for an ABC project. Let’s say that the full range of activities associated with a distribution channel cost object is 30 activities. That’s a lot of activities. The accountant might throw out half of them, because the data collection is too difficult, or it may not even be possible to collect the data, or the data collected will be too unreliable, or maybe there’s not enough funding for a full-blown project. This is a significant issue, so the accountant may spend a lot of time sorting through the various activities and deciding which ones to keep and which ones to throw out.
Summary
And that’s it. My intent was to give just a taste of what ABC is about, because it’s a complicated process, and delving into it in detail could take hours. A major takeaway is that ABC is useful, but only if it’s precisely targeted. Conversely, it’ll probably fail if you try for a broad, company-wide rollout of the concept.