As the name indicates activity based costing is a system where the fundamental focus is on activities as the cost objects. The cost of these activities is then used as building blocks to compile the cost of other cost objects. An activity based costing system involves the accumulation of the costs of the significant activities of an organization as well as the assigning to goods or services in accordance with how the activities are used in the production of those goods and services.
Activity based costing principles are based on knowing what activities cause the application and usage of resources. The strength of activity based costing is the ability it has to exactly delineate cost and non-financial data. This includes the illustration of the relationships between the two entities.
The object of activity based costing is to trace the activities in order to focus the attention on why resources were consumed. In organisations using the activity based costing approach the cost-management purpose has replaced the product-costing purpose as the primary use of activity based costing. Other significant applications of the activity-based approach comprise activity performance measurement, cost modelling, output decisions and budgeting uses.
When building an activity based costing model, costs are allocated to activities, and costed activities are allocated to cost objects. The overhead model is easy to construct - it basically consists of budget centres.
Two Dimensional ABC Model
One approach is to analyse activity based costing with the use of a two-dimensional model. The model is used to explain the components involved and depicts the flow of information in the activity based costing system. The information in the activity based costing system can be viewed from two perspectives. The one view being the cost view and the other the process view.
The cost view in the model shows the flow of costs from the resources via the activities to the products and services. This means that the resources consumed by a certain activity would be traceable to the output via the said activities. From this it can thus be deduced that if the number of specific activities involved in the particular output is known, then the resources consumed could be established. The cost view in this model thus summarises the principal idea underlying activity based costing.
Resources are depleted by activities and activities are absorbed by outputs. The cost view is represented by the vertical flow direction in the model. The cost view reflects the need for organisations to assign costs to activities and cost objects in order to assist in crucial decisions. These decisions comprise of pricing, product mix, sourcing and product design decisions, as well as determining priorities for improvement attempts.
The cost view provides information about activities, and cost objects. The underlying presumption is that cost objects cause the need for activities, and activities cause the need for resources. The flow of cost is in the opposite direction in the model. The flow of cost is from the resources to the activities and then from the activities to the cost object.
The cost information obtained from the activity based costing system ensures an accurate product cost as well as high-quality information about activities and cost objects.
Activity based costing systems ensures that significant activities are identified and attaches cost to them. With the cost of activities known it is easier to understand why resources are used.
It makes sense to focus just as carefully on non-production activities as on production activities. A review of a number of company income statements indicates that more than 50% of the running costs of the companies were non-production cost. The traditional costing systems completely disregarded these costs in the decision making process.
The horizontal flow in the model represent the process view as well as the flow of information associated with the activity. It provides information about the work done in an activity and the relationship of this work to other activities. During this process information is gathered on the extent of the activity during the accounting period. It is this assembling of information that supply the information required to complete the costing of the outputs.
The process view includes information about cost drivers and performance measures for each activity or process in the value chain. These cost drivers and performance measures are essentially non-financial. The data collected also provides useful information necessary for the performance evaluation. Performance measures describe the work done and the results achieved in an activity. They describe how well an activity is performed in meeting the needs of the company and the customers.
Performance measures include measurements of efficiency, time taken and output quality of the activity. It is said that the activity based costing process view provides operational intelligence about the workings of the organisation. In other words, information regarding outside factors that determines how frequently an activity is performed as well as the attempt necessary to perform the activity. Operational intelligence contains information about the performance of an activity.
The strength of combining activity costs and non-financial information is best illustrated during the process of identifying areas for improvement on the basis of possible returns. The activity based costing system allows the manager to calculate the cost of defects, allowing focus of efforts to be aimed at corrective actions with the highest returns.