Activity Based Costing (ABC) has long been the preserve of forward-thinking manufacturers who want an alternative to the traditional volume-led approach to standard costing techniques. The latter can seriously mislead the decision-making process when based purely on volume- or time-driven allocation of indirect costs. When an ABC exercise is completed, there are almost always some seriously raised eyebrows when the results are considered.
ABC can, subject to being able to identify cost groups and their behaviours, give a much more ‘accurate’ product costing. In fact, rather than simply applying the techniques to manufactured products, organisations are applying these methodologies more and more to service-based sectors – the NHS in particular are becoming heavy adopters of ABC.
Faced with the tangled web of ABC analysis, many people will run a mile – but, as I say for many complex issues, you only need to break them down into manageable portions and the complexity starts to float away (I admit, however, ABC is never going to be ‘easy’ – identifying the right activities and the appropriate level of detail to drill into can make or break the project).
So, how do you unravel Activity Based Costing into five easy steps?
- Assign all direct costs (to products, customers etc). Simply put, if you can easily identify what a cost belongs to, then it’s a direct cost; if you can’t it isn’t.
- Assign all remaining (indirect) costs to the ‘activities’ of the organisation such as engineering, customer support, development etc. Activities are key (hence the name ABC!) and all activities used in the generation of a product/service must be identified. They may need to be disaggregated if different significant costs behave in different ways (see below).
- Determine the ‘cost drivers’ for each activity i.e. what makes the costs change – for instance, is it time (e.g. engineers working on a machine setup), quantity (e.g. packaging per unit), or sales value (e.g. 5% sales commissions) etc.
- Determine, for each product/customer etc, how much of each activity is consumed – this must be in the same terms as the activities themselves; then you can assign the cost of each activity to each product/customer etc, based on the activity rates and consumption per unit.
- Take the direct costs, and add on the indirect activity costs, and you have your total cost.
With a good set of ABC costings, you can then start to make value-adding decisions, within a framework of continuous improvement, on who are your best and worst customers, what are your best and worst products, how costs can be predicted, what drives good and poor performance, what costs may not be adding value (and therefore eliminate waste), and more…
I have carried several major ABC projects, successful in terms of improving the bottom line significantly; this would not have been the case if the companies concerned had continued with their previous strategies.
So, in these tough times where every day counts, what are you waiting for…?