Activity-Based Costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect cost (overhead)into direct costs.
In this way an organization can establish the true cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced. In a business organization, the ABC methodology assigns an organization’s resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. Traditionally cost accountants easily added a broad percentage of expenses onto the Direct cost the indirect cost. However as the percentages of indirect or overhead cost is technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad ‘on-cost’ percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
The concepts of ABC were developed in the manufacturing sector during the 1970s and 1980s. During this time, the Consortium of advanced learning idea a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.
Rob Robert S Kaplan Balanced score card these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems are often unable to determine accurately the actual costs of Production costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products. Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products. Activity-based costing was first clearly defined in 1987 by Robert S Kaplan and W.Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.
Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this.
¾ Cost allocation
¾ Fixed cost
¾ Variable cost
¾ Cost driver
¾ Cost driver rate
Direct Labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product’s transactions takes at the counter and then by measuring the number of each type of transaction