Activity based costing is essentially a change in accent. People carry out activities and activities consume resources. Therefore, by controlling activities the manager is ensuring that costs are controlled at their source. A wise manager will not concentrate on how to calculate product costs but will concentrate more on why the costs were there in the first place. When designing an activity based costing system this should be used as a departure point.
In order to design an activity based costing system it is important to remember that the objectives should be met at the minimum cost and complexity. To be successful, the final activity based costing system should provide the right kind of information at the right level of detail. In addition to this the design of the system should be as simple as possible without being too simple, since it may report inaccurate costs if it is too simple. The answer is to strike a balance between simplicity and complexity.
In addition to this, performance measures should be identified at process level and for key activities. They should be used to monitor and evaluate activities or processes and must be used to promote consistent improvement. This should be done without unnecessarily complicating the design of the system.
It is true that managers too often focus on precision and ignore how accurate the data used are. This can lead to the erroneous assumption by a manager that information is more exact than it really is.
The seven assumptions underlying the design of an activity based costing system are that:
Activities in a business consume resources
Producing products or servicing customers utilize activities
The Business model is focussed on consumption rather than spending
Consuming company resources can have numerous causes
A wide variety of activities can be identified and measured in any company
Cost pools should be homogeneous
Costs in each pool are variable (strictly proportional to activity).
There are a number of different approached possible when introducing an activity based costing system, the following steps are generally accepted to be present in most system implementation processes:
STEP 1: Identified all the major activities.
STEP 2: Established the major resource pools.
STEP 3: Collected cost driver information, assigned costs to each activity, and calculated cost per outcome.
STEP 4: Analysed processes with costs, outcomes, and benchmarks.
To introduce an activity based costing system, it is essential to combine it with practical business operations. The elected function should be profitability management which will provide an ideal pilot area for learning about activity based costing whilst, at the same time, furthering company understanding about the relationship between product turnover and customer dividends.
Different authors suggest different methods to be followed in designing an activity based costing system. From the various proposed methods it is recommended that the following design steps are followed:
Process Value Analysis
The first step involved in the design of an activity based costing system should be to do a process value analysis. A process value analysis is a systematic method of identifying activities involved in the processes of the organisation.
When doing this the first stage is to identify the primary activities in the organisation. Here it is important to match the detail of the activities to the purpose of the final costing model.
In order to achieve simplicity, the aggregation of related activities to balance conflicting objectives, can be effectively used. Activities that are too small and insignificant should be combined to reduce system confusion. A clear and consistent description of activities makes it easy to isolate similar activities or processes. The isolation and clear documentation of the value adding activities are essential for the next step in the process.
Creating Activity Centers
Once the process value analysis is complete the next step is to create activity centres. An activity centre can be defined as a cluster of related activities. The purpose of activity centres is that they give structure to activity information in the system and facilitate reports about related activities. In activity based costing systems the primary element is activities. The next step is the assignment of cost of various activities to activity cost pools and then to assign these costs to products.
It is unnecessary and costly to consider every single activity as an independent activity centre. It is better to integrate several associated activities into one cost centre, to decrease the amount of detail and record keeping cost involved. A two-phased cost-driver approach is recommended to assist with the pooling of costs into activity centres before subsequent allocation to products.
The result of activity combining is to better the correctness of product costs, the actual improvement lay in the capability, first, to query the presence of activities and associated costs and, second, to begin measuring activity achievement.
An activity based costing system assign costs to products or customers in two stages. In stage one, costs are assigned to activities, and, in stage two, costs are assigned from activities to products or customers with the use of cost drivers. This should be kept in mind when creating activity centres during the design of the system.
Whilst every effort should be made to calculate activity based costing for all products, the real emphasis should be placed in ensuring the accuracy of activity based costing attributed to product families at which level the decision making process was most critical. The greatest accuracy in costing is achieved by recognising four levels of activities, with several of these levels then subdivided into specific activity centres.
This approach is given substance when one views this as four general levels of activities
1. Unit-level activities
A unit level activity is an activity performed on units of products. Activity drivers for this type of activity can be direct labour hours or machine hours.
2. Batch-level activities
Batch activities are performed on batches of products rather than individual product units. Activity drivers for this type of activity can be number of movements or number of runs.
3. Product-level activities
Product activities benefit all units of a particular product. Activity drivers for this type of activity can be number of machine set-ups to produce a batch of products or engineering change notices.
4. Facility-level activities
Facility activities sustain the general processes in a facility. Facility level costs include items normally described as general overheads. This may include financing and other management cost not attributable to any of the previous levels of activities.
In order to achieve the greatest benefit from the introduction of an activity based costing system it is imperative to isolate the various levels of activities in accordance with the four activity levels described above.
Defining Resource Drivers
The next step in the design process of an activity based costing system is defining the resource drivers. They in turn define the resource consumption of activities. The factors that have to be considered when defining a resource driver, includes the ease of collecting relevant resource driver data and the level to which the resource driver really measures the consumption by the product.
The adoption of the activity based approach to cost collection, revealed that there were logical separations in the manufacturing and distribution processes for which costs were easy to pool. More significant is that completed products are directed through different sub-processes, depending on type and complexity of the manufacturing process.
This results in two major advantages. The first is that the assignment of costs from activity pools to products can be done in a far more concentrated and differentiated way. The second is that the activities themselves can be measured and targeted for improvement. It is therefore important to note that cost should be traced wherever possible and only allocated in the final stages.
In the first generation systems, activities were distinguished initially, and costs were allocated to corresponding activities. Product costs were evolved from this. In the second-generation system, processes were distinguished and activities linked to the processes.
When implementing an activity based costing process more efficiently a company should define processes before it attempts to associate related activities to the defined process. Processes should not be forced or defined to fit activities; activities should fit processes. It is for this reason important to attach labels that enhance the meaning of the activity based information to the data in the system. Some sensitive attributes should be left to the user to create.
Selecting Activity Drivers An activity driver is the factor that measures the activity consumption of a cost object. A cost object is generally defined as the reason for carrying out the activity.
Activity based costing requires that attention be given to a different product costing approach. The primary contribution of the activity based costing system is the recognition that cost drivers may encompass more than one facet of an organisation. Utilizing an activity based costing approach correctly revealed that low-volume products having significant transaction costs were unprofitable.
The successful selection of activity drives will result in dividing the costs into value-added and non-value-added components, with cost drivers separated into volume-related and transaction-related categories. This will result in approaching cost drivers as a way to manage and control expenses.
When selecting an activity driver, care should be taken as not all cost drivers are volume related and sometimes the drivers associated with transactions have a greater cost than the cost drivers associated with volume.
Activity drivers merge the requirements that cost objects places on activities. The importance of selecting activity drivers accurately cannot be over emphasised. This will impact on the accuracy of the costing of cost objects.
The design of an Activity Based Costing system is a complicated and complex process that needs the cooperation of many different functional heads in an organization. To simply match the level of the activity driver with the activity does not always ensure that the desired level of accuracy is achieved.
A part of the answer may be found in involving the correctly motivated individuals at the correct time with a strong mandate and then to let the team establish the correlation between the performance of the activity and the activity driver.