Activity Based Costing

Activity-Based View of Cost 

The groundswell of ABC occurred in the mid-1980s. This approach was born to emphasize what is being done and what it costs to do it. Activity-Based Costing provided for a real understanding of the activities being performed by each department. While a direct cost method may assign costs to the correct objects, without the ABC view, it is still difficult to understand how to reduce costs or what the resources are actually doing. 

The view of ABC originated in the resource center (albeit the resource view was most likely embedded within the general ledger [G/L] account coding), but the focus was to “convert” the G/L account view of the resources to a process per-spective. Exhibit 1.2 illustrates a traditional ABC cost flow. In this example, the G/L account view within the  Distribution Support resource/cost center is con-verted into the view of the processes supported by that center, for example, Enter Documents and Schedule Laborers processes

The normal conversion routine was to establish a “resource driver” via an interview process, thereby gaining a snapshot perspective of the effort expended on each activity. The most common process breakdown was formulated by inter-viewing the resources or the cost center manager to determine a percentage of time spent on each process. This weighting factor became the resource driver or apportionment tool for costs assigned to the process view. 

Achieving the activity view in this manner did provide an activity perspec-tive on costs. However, the perspective was achieved based on a primary as-sumption that, in order to reduce model maintenance workloads, the relationships would be frozen in a given point in time, for example, annually, semi annually, or quarterly at best. Also, in addition to the risks posed by using a stagnant model, the new activity view sacrificed and minimized the perspective of the resource view. The limited expression of resources along with the technical limitations of the computer hardware used to accommodate the models led to a number of weaknesses in the ABC models and in the information these models provided. 

Weaknesses in the ABC models were:

• Models were backward-looking, using only historical data. The models had no predictive perspective at all.

• Causal relationships, particularly those between resources and processes, were expressed only in value or in ratios/portions of value.

• Models were usually of a step-down nature, that is, costs flowed from re-sources, to activities, to final cost objects. Fully burdened resource costs were not provided.

• Models were very maintenance intensive. 

• Models had limited ability to deal with complexity.

• Because they were stand-alone models, there was the need to “feed the beast” with all the information required to run the model.

Weaknesses in the information provided by ABC were:

• All costs for a period would be spread to products without regard for actual utilization levels. This full absorption approach spread costs to products indiscriminately. Companies that utilized ABC information potentially faced the fixed cost death spiral.

• Because the nature of cost was viewed inconsistently, the ability to provide accurate gross and contribution margin was limited.

• From a control perspective, the capabilities were limited in that plans were static, and the ability to generate authorized reports generally was not supported.

• Limited variance calculations was available.

• The weak resource expression led to ineffective capacity management capabilities.

• Activity-Based Budgeting (ABB) efforts have a tendency to overstate the budget because all costs are usually extrapolated, including fixed costs.

Traditional costing certainly no longer supports management accounting needs. ABC provides more analytical capabilities, yet, as can be seen from the weaknesses listed, it does not completely support the needs of management ac-counting. Therefore, there is an identified gap in the tools and abilities to fully support management accounting.