Using Activity Based Costing (ABC) as an Activity Based Management Tool

Activity Based Costing (ABC) is perfectly suited as an activity based management tool as it primarily focuses on actions that drives the cost. For a manager to effectively manage costs he or she should focus on the items that cause the cost. It is easier to manage the events that bring about the cost than to manage expenses directly.

The problem with managing expenditure is that it is reactive of nature and under the traditional costing regime it is often unsure what causes the expenditure. This could easily result in a manager deciding to cut a particular expense item only to find out that the net cost increased as it had no impact on the production expenditure but resulted in a reduction in productivity.

In most cases the traditional costing system, based on the traditional accounting system, sufficiently determines the direct costs of the products and services of a company but results in problems when allocating overheads. The direct costs normally include expenditure on material and labor. When an ABC system is introduced it usually focus on indirect costs such as manufacturing overheads, marketing costs, and general administrative costs. With this focus in mind it is easy to understand that the primary goal of activity based costing is normally to reclassify the indirect costs to direct costs. The result of the re-categorization of the costs is that the accuracy is significantly improved.

Activity Based Costing (ABC)

Fundamentally this is a method of allocating and assigning the cost of production to the commodities produced in order to accurately evaluate the cost of the items in the inventory. It should be made clear up from that this system should only be used for decision making purposes regarding production, pricing and marketing and not for accounting purposes.

In comparison to the traditional costing system, activity based costing systems allocate overhead costs for each production activity before the costs of the products, services are added. These cost objects are grouped and then called cost activities.

One of the most crucial characteristic of this approach of recording and reporting of costs is the activity analysis. When conducting the activity analysis the output measures of activities and resources and their effects on the costs of making a product or providing a service is determined. These cost drivers provides the foundation for treating the misrepresentation that is inherent in the design of the traditional costing system.

When focusing on the cost drivers the manager can focus on the items that significantly contribute to the cost of the item or service and thus have a better chance of reducing the cost without impacting on productivity or the quality of the product.

One of the results of introducing an activity based costing system is that the measuring of product cost is more accurate and thus the making of a product mix and product pricing decision are easier. In addition, the pooling of costs by activity provides information that makes the planning and controlling of costs more effective.

By allocating costs to activity pools where the cost driver is identified, accurate analysis of the costs that will be incurred can be done, thereby improving the ability of the manager to forecast cash flow.

The ability of an this type of costing system to effectively identify poor product quality, poor product design and poor market penetration can be negated by managing these items based on the information the system provides.

A key ingredient to successful implementation of an ABC system is to get managers to focus on the process rather than on the overheads or the costs that needs to be managed. The implementation of this type of costing system is more of an organizational change management system than the implementation of a new costing system. The approach of managers and the way they use cost information derived form it is completely different that that from the traditional costing system. The approach is more focused on the managing of the activities than that of managing people.

Activity Based Management

A clear distinction should be made between cost information required for accounting purposes and cost information required for making sound management decisions.

Using costing information derived form the ABC costing system to improve the management of product quality, product design and market penetration is called activity based management. The purpose of this approach to management is to provide managers with a tool that will help to focus their attention on the items that will enhance the customer value in order to increase profits.

The activity approach to management frequently uses techniques associated with the evenly named costing system to manage issues that go far beyond manufacturing costs. This is especially true when financial costing information is needed for decision making purposes in the organization. When the cost of the inventory is required for accounting purposes the traditional accounting system should be used to report this, on the other hand, should the cost of the inventory be required to make the relevant management decisions the activity based costing system would produce better results.

Given that the focus of the activity type costing approach is the actions that drive the cost, managers could implement such a costing system with the aim of facilitating cost management. In order to provide the correct information at the correct time the implemented cost recording and reporting system should provide quality information at intervals that is dictated by the need to make decisions rather than by the system.

The management system that is based ion the actions normally focuses on establishing value added costs and non-value added costs. A cost is deemed to be a value added cost if the event that is driving that cost cannot be eliminated without negatively affecting the value of a product as perceived by a customer. On the other hand a non-value added cost is defined as the cost of an event that can be eliminated without reducing the perceived value to the customer. The successful manager will reduce the non-value added costs to the absolute minimum if they cannot be eliminated. This can often be achieved by the redesign of the process flow or production plan. This manager will also ensure that the cost drivers of the value added costs are performed as efficiently as the process will allow.

Conclusion

Activity Based Management should not be seen as the panacea to all cost management problems. It should rather be a natural progression of systems to improve management systems as a whole.

Activity Based Costing is seen as the information system that provides the cost and profitability of products or services while the management system entails the management events to reduce the cost and improve the perceived value by the customer. The actions include factors such as utilization of machinery or resources, customer profitability, distribution channel effectiveness and other managerial issues.

It is only reasonable to expect that a costing system that is based on actions and events will be implemented prior to the implementation of a management system that utilizes the information produced by this type of costing system.

(c) 2009 Carl Marx