In previous posts in this series (An introduction to Activity Based Costing and A worked example of Activity Based Costing), I’ve talked about the theory behind Activity Based Costing (ABC), and illustrated how it works with a simple example based on customer profitability.
ABC is particularly useful when:
- Resources are not directly attributable to outputs
- Indirect costs are significant
- Processes/activities are highly standardised
- Margins are tight
- Shared services (IT, HR) costing is important.
Here I’m going to present a range of other use cases that stem from this approach.
As we saw before, activity-based costing is useful for answering questions about the cost (and hence the profitability) of cost objects. Typical questions that we could answer might be:
- Which products are the most profitable?
- Which customers are the least profitable?
- Which are our best and worst sales or distribution channels?
In order to do this, we apportion our resource costs to activities, and then apportion our activity costs to cost objects. This we do in order to follow the basic principles of ABC:
- Activities consume resources
- Customers, products and channels consume activities.
So, as a side effect of deriving costs by cost object, we also get to see what each of our activities is costing us, which opens up a number of other potential uses of the model’s results.
Shared service costing
One consideration that we haven’t mentioned so far in this series is that some activities might not be directly related to producing products or serving customers. Some functions within the business – IT, for example, or HR – exist to provide internal services, also known as “shared services”, within the company.
ABC is often used to model this idea. The activities for the shared services are costed as normal in ABC, but these shared service activities are consumed by the other areas of the company, in the same way as resources might be consumed.
Taking IT as an example, this costing method provides a way for the IT department to establish a fair recharge rate for its services. The IT department can confidently develop an internal rate card that lets it cover its costs, while justifying its charging levels, helping internal customers understand why a particular service costs a certain amount. Users then become responsible for the amount of internal resource that they use, and can be prevented from adopting an “all-you-can-eat” approach to the services. The services can also be measured against the same service provided from elsewhere, possibly an external supplier, allowing the service to be fairly compared to the market.
Budgeting and forecasting
Activity based costing offers an alternative, more logical way of approaching the budgeting and forecasting process. Because it explicitly makes the connection between activities and resource consumption, ABC makes it possible to predict the resources needed to support a change in the level of activities. For instance, if we wanted to build the budget around a 10% increase in the volume of sales orders, what would be the impact on the resources required? It’s certainly not a 10% increase across all resources. So what is it? Well, because the ABC model knows about the relationship between the driver volumes and activity costs, it can calculate how the cost of each affected activity will have change in order to meet the new sales objective, and because it knows about the relationship between activities and resources it can also work out what increased resources are needed to support the new level of activity.
Given a well-defined activity dictionary, it is possible to compare the costs of the same activity in different parts of the organisation. If there are variations in the cost, we can easily highlight which areas are doing the activity most efficiently, and which not so much. Then we can investigate why, and if there is best practice that can be identified, we can introduce that practice to the rest of the organisation, or if one area is struggling we can help them do the activity better.
On one level, you can use activity-based costing to analyse the cost of the same activity carried out in different parts of the organisation. If someone is doing it at a lower cost than someone else, what is it that they are doing better (or worse?) that makes the difference?
On another level, you can also use ABC to quantify the cost of non-value added activities, i.e .those activities that don’t add to the value of the outputs, but are more likely caused by process failure within the organisation. These would be activities like “Reject Component”, or “Chase Customers for Payment”, or “Issue Refunds”, or “Deal with Complaints”. You can’t realistically hope to eliminate all of these, but you may plan to reduce them. This will bring down the cost base in the model, and the model will then be able to work back to calculate the revised level (and cost) of resources that will be needed during the budget or forecast years.