What is ABC costing? what advantages does it have over other costings?

The idea of ABC costing is not new; rather, it dates back to the 1970s, with its development primarily attributed to two accounting professors: Robert S. Kaplan and Robin Cooper, from Harvard University.

In 1987, Kaplan and Cooper published an article in the Harvard Business Review titled "How Cost Accounting Distorts Product Costs," which drew attention from the business and academic community to ABC. This article marked the beginning of ABC's popularization as an alternative and more precise cost management methodology.

But what is ABC costing?

Activity-Based Costing (ABC) is a cost accounting method that allocates costs to the activities that generate them, rather than directly assigning them to products or services.

Instead of using a generalized and traditional approach, where costs are distributed uniformly based solely on production volume or sales, ABC seeks to identify and assign specific costs related to each individual activity, aiming for a cause-and-effect relationship.

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This more precise and detailed approach of ABC allows companies to better understand how costs are incurred in their operational processes and where real value originates within the organization. By identifying resource-consuming activities and assigning them corresponding costs, ABC provides a clearer view of the actual costs associated with producing each product or providing each service. This, in turn, enables more informed decision-making in areas such as pricing, cost management, process improvement, and resource allocation.

Differences between ABC costing and other costing methodologies

Focus on activities and resources

While other methodologies often rely on general cost allocations to products or services, ABC focuses on identifying and assigning costs to the specific activities that generate those costs. That is, it creates an intermediate layer between costs and products or services. This layer is determined by activities and processes, hence its name. This additional layer allows for greater accuracy by linking costs directly to the activities that cause them, rather than arbitrarily assigning them to products or services.

Use of multiple cost allocation bases

ABC uses multiple cost allocation bases, as opposed to the use of a single base, such as production volume, which is common in other methodologies. By using multiple bases, ABC can more accurately capture the complexity of processes and activities within an organization, by distributing costs based on resource consumption.

Greater accuracy in cost allocation

Due to its detailed focus on activities and resources, ABC tends to provide a more precise and granular cost allocation. This allows for a better understanding of the true costs associated with the production of products or provision of services, thereby facilitating more informed decision-making.

Focus on value management

ABC is closely related to value management, as it helps identify where value is created within an organization by linking costs to activities that directly contribute to value generation for the customer. Conversely, it also allows for the identification of activities that do not add value, to simplify, automate, or eliminate them. This enables better resource management and greater potential for improving efficiency and profitability.

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Example of ABC costing

Theory is best understood with an example. This is an example overly simplified for academic purposes. Let's suppose we have a company that manufactures two types of mirrors: Large Mirror and Small Mirror. To manufacture these products, the company carries out three main activities: raw material procurement, raw material processing, and final assembly.

First, we identify the costs incurred to produce a batch of 2000 mirrors.

Traditional volume-based costing

Applying volume-based costing and if we produce equal quantities of each type of mirror (1000 units of each), the cost allocation would be as follows:

With a unit cost of $4.50 for both.

ABC costing

Now, we will allocate costs to each product using ABC. Suppose that, after a detailed analysis, we determine that material and labor costs are distributed in each activity as follows:

Then, we determine which driver to use to distribute costs to the products.

Now, we calculate the total costs assigned to each product:

With ABC, not only does the total amount vary due to a more precise allocation, but also the unit cost varies to $3.60 for the small mirror and $5.40 for the large mirror.

Dilemma

For example, if a customer requests a contract for 4,000 units of the large mirror. With the traditional costing method, knowing that the unit cost is $4.50, a $1.00 profit margin is added for a final unit price to the customer of $5.50.

Under this scenario, the theoretical total profit would be: 4000 units times $1.00 profit per unit = $4,000.00.

Now, if we use the ABC costing methodology, the results are very different. In this case, the unit cost is $5.40. If we maintain the same unit price defined with the traditional costing of $5.50, in this case, the unit margin would be only $0.10 while the total profit would be only $400.00. (4000 units times $0.10). Ten times less than with the traditional costing method!

If the decision were made based on the traditional costing results to eliminate the production of small mirrors and only produce large mirrors, the company's profits would be reduced by 10 times, putting it at risk of bankruptcy. This demonstrates that ABC costing provides more accurate information for decision-making.

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Advantages of ABC costing:

Precision in cost allocation

ABC provides a more precise allocation of costs by directly linking them to the activities that generate them, as well as their consumption. This allows for a clearer understanding of the actual costs associated with the production of products or the provision of services.

Identification of value-added activities

By breaking down costs based on activities, ABC helps identify which activities add value to the final product or service and which do not. This can lead to process improvement and automation, reduction, or elimination of activities that do not add value.

Informed decision-making

As seen in the previous exercise, by better understanding how costs are generated in the organization, managers can make more informed decisions about pricing, cost management, resource allocation, and process improvement.

Adaptability to product and service diversity

ABC is flexible and can easily adapt to a wide range of products and services, making it suitable for companies with varied product lines or customized services.

Disadvantages:

Cost and complexity of implementation

Implementing ABC can be costly and time-consuming. Additionally, the process of identifying and tracking activities can be complex and require significant resources. It is essential to have specialized software tools to better manage this complexity and be more efficient with the resources allocated to the model.

Subjectivity in activity identification

The identification and classification of activities can be subjective and open to interpretation. This can lead to discrepancies in results and difficulties in comparing between different units or departments within the organization. Having a centralized team leading the process and consulting with experts is recommended.

Possible excess of detail

In some cases, ABC can lead to an excess of detail in activity identification, which can hinder effective cost management and lead to excessive analysis. In such cases, it is essential to have a clear understanding of the model's objective and seek appropriate guidance to develop a sustainable model over time.

Resistance to change

Implementing ABC may encounter resistance from the organization's culture, where employees are accustomed to more traditional and simple accounting methods. Effective training and communication are key to overcoming this resistance and ensuring the success of ABC.

Conclusion:

Activity-Based Costing (ABC) represents a significant evolution in cost accounting, offering a detailed and precise view of how costs are generated within an organization. Unlike traditional methodologies, ABC focuses on identifying and assigning costs to specific activities, allowing for a more accurate and detailed allocation of costs. This, in turn, facilitates more informed decision-making in areas such as pricing, cost management, and resource allocation. Although ABC offers numerous advantages, such as identifying value-added activities and adapting to product and service diversity, it also presents challenges, including implementation costs and complexity, subjectivity in activity identification, and resistance to change. However, with careful implementation and effective management, ABC can be a powerful tool for improving efficiency and profitability in various business environments.