Avoiding Common ABC Costing Errors

Have you ever tried to divide the ingredients of a recipe among different dishes without considering what each one contains? Sounds absurd, right? Well, the same happens when, in a cost model, we try to allocate expenses uniformly without considering what each product or service consumes. This article seeks to ground one of the most important – and often misapplied – concepts in cost management: allocation. Through simple examples such as a pastry shop, you will understand how this principle is key for models to reflect the operational and financial reality of a company.

Assignments aren't just an accounting task; they are the basis for making strategic decisions. If we allocate wrong, we run the risk of distorting the results and ending up making wrong decisions. And although it may seem simple to say, "I allocate according to what is consumed", the reality is that it is often not so obvious. This is where ABC (Activity-Based Costing) models become relevant, helping us to better connect resources with activities and products. In the following sections, we will explore the most common mistakes in this process and how to avoid them to build more accurate, sustainable, and useful models for decision-making.

What is a cost allocation in a cost model?

Let's use a simple example to understand it. Imagine you have a cake factory, and you make three types of cake: chocolate, vanilla, and carrot. You have many ingredients such as: Flour, Sugar, Brown Sugar, Eggs, Butter/Oil, Milk, Cocoa/Chocolate, Vanilla Essence, Grated Carrot, Cinnamon/Spices, Nuts (optional), Baking Powder, Ganache/Sprinkles, Frosting/Fruits, Cream Cheese (frosting).

But not all cakes use the ingredients equally.

Chocolate Cake

• Use cocoa or chocolate, which is usually a more expensive ingredient.
  
  
• It requires chocolate chips for decoration, which adds value and complexity.
  
  
• Use common ingredients such as flour, eggs, milk, and butter.

Carrot Cake

• It has grated carrots, which implies more preparation and time.
  
  
• It uses spices (such as cinnamon) and nuts, which makes it more complex and expensive.
  
  
• It is decorated with cream cheese, a more expensive ingredient than regular frosting.

Vanilla Cake

• Use more basic and economical ingredients, such as vanilla essence, flour and sugar.
  
  
• It does not contain additional ingredients such as nuts, carrots or chocolate.
  
  
• It can be decorated with a simple icing or fruit (optional).
  
  

So, it wouldn't be fair to allocate all the ingredients equally between the three cakes, right?

To do this, we resort to cost allocations

"We are going to see what ingredients each cake needs according to its recipe and then, we assign each cake the ingredients according to what it actually consumed. This is just what is done in cost allocations. In the following table we see how each of the ingredients is assigned to the different cakes according to the criterion of whether or not the product has this ingredient in its recipe.

Under this principle of causality, it would be incorrect to assign grated carrots to chocolate cake, since it does not contain this ingredient. Well, the same applies when we make the allocations in an enterprise cost model. The principle of causality must always be considered. It seems obvious, but in practice it is not so obvious. Not all expenses can be found to have a clear causality to justify the allocation. This is where the importance of ABC cost models comes in.

Allocations to ABC Cost Models

In many ABC models, especially those that are in early stages or were implemented without expert accompaniment, assignments can become the Achilles' heel of the system. To better understand how an ABC cost model works, you can consult my other article called What is ABC costing? And what advantages does it have over other costing?

Let's start with the most common mistakes and how to prevent them:

Ignore unseen or unlogged activities

In administrative or back-office processes, many activities are "hidden" (such as time spent on emails, validations, or rework) and, therefore, are not properly assigned. If you are interested in knowing more about the definition of activities, you can consult my article called APQC, the forgotten resource for benchmarks.

To solve this, you can hold workshops with the operational teams to map "invisible" activities. Tools such as interviews or process maps are key to detecting these cost leaks. Also, the use of the APQC framework to ensure that nothing is being left out.

Overly detailed assignments that don't add value

A common mistake is to create models with too many activities and drivers, generating operational overhead without much analytical benefit. Many elements in the model mean many assignments. For example, if I have expenses related to payroll, vacations, Christmas bonuses, bonuses, travel expenses, etc. And I have to assign them to 20 activities, in the end I will have 5 expenses x 20 activities = 100 assignments.

To solve this, we usually apply the 80/20 rule. Identify the resources that actually account for the most costs and focus on those for allocations. Less is more. In the previous example, if these expenses use the same driver, then they could be grouped into what we call a pool of resources called Personnel Expenses and we assign this to the 20 activities = 20 assignments, thus reducing the number of assignments and therefore the complexity of the model

Not adjusting assignments on the first runs of the model

It is very normal for assignment errors to exist in models that have just been built. It is difficult to detect them at the time of construction, so it is necessary to run the reports and through these verify if the expenses that are being attributed to each product make sense.

The assignments tend to be static, that is, once they are validated it is not necessary to change them. However, there is another time when a readjustment of assignments is necessary and that is when there has been a restructuring in the organization, there are new divisions or units, or a technological change has been implemented in the manufacture of products. In all these cases, the assignments must be re-analyzed and the necessary adjustments made.

Dilemma about which scheme to use

In the past, when models were made in a simple spreadsheet, the tendency was to use a very linear scheme of assignments. Typical ABC costing has three phases, each of which maps to the following:

Resources -> Activities -> Cost Objects (Products and Services)

Under this scheme, we simply had three types of allocations, namely: from resources (expenses of the period) to the activities and from these to the cost objects. There wasn't much to get lost in.

However, with today's modern costing systems such as MyABCM, we are no longer forced to follow this scheme, but we have more freedom. That is why the question arises about which schemes to use. Let's look at some of them:

Cascading Scheme

In this diagram at the top, we have the resources, which are assigned to the primary and support activities. Then the support activities are assigned to the parent activities and finally these to the cost objects.

In practice, something like the following scheme would look like. As an example, the assignments were simplified to make it more understandable.

This is the simplest scheme and therefore also the most used since it is easier to understand and execute in any cost tool, even if we are developing the model in Excel.

Variant with Horizontal Assignments

This scheme is based on the previous one, but horizontal assignments are also made. That is, between elements that are on the same level. For example, in our case the Information Technology Management activity not only supports the primary activities, but also some support activities. With this Information Technology variant, you would also be assigning cost to other support activities. The same would be done by Human Capital Management.

With this variant, we see that the activity of Managing Financial Resources in order to be executed must receive support from Human Capital Management and support from Information Technology.

This variant is very useful if we want to evaluate eliminating a certain activity and requesting the services of a third party as an outsourcing. To do this, we must know what the total cost of the activity is, with all the support it requires to be able to make a fair and objective comparison.

Variant with Recursive Assignments

To add a little more complexity, there is the option to perform recursive mappings. By this I mean that, for example, the Human Capital Management activity needs technological support to perform its tasks, such as software use, network use, licensing, etc. And on the other hand, the activity of Information Technology Management also requires support from Human Capital, since technological people need to be hired, trained, paid their salary, etc.

Recursive assignments have the advantage that in one way or another they reflect all the costs incurred in each area to carry out their work. On the downside, they have three major drawbacks:

1. Software that is designed to handle this complexity is required.
   
   
2. Extra complexity is added to the model, both in the design and execution of the model. On the other hand, the data from cost centers at the accounting level will not necessarily coincide with what is reflected in the model.
   
   
3. They are difficult to understand, since it seems that the cost is doubling. I say it seems because in the reports the costs by area, as I indicated in the previous point, will not necessarily coincide with what is reflected in the model. However, with the right software this would not be a problem on a technical level to ensure that the model is square.
   
   
   
   

Although current software can perform this type of recursive assignment, preventing them from becoming an infinite cycle and allowing the model to be squared, I still do not recommend them since I consider that the disadvantages outweigh the advantages.

As complex as it may seem at first, the true value of a cost model is not in how many allocations it has, but in how well they reflect the reality of the business. Remembering the principle of causality is essential: we assign what is actually used, no more, no less. It is not a matter of filling the model with unnecessary formulas and details, but of making the information useful, understandable and actionable. A well-structured model will allow you to clearly see where the true cost drivers are and where there are opportunities to improve efficiency.

Finally, don't forget that cost models are living tools. They require review, adjustment and, above all, criteria. Don't be afraid to simplify where it makes sense or dig deeper when necessary. Learn on tools, methodologies like ABC, and frameworks like APQC to ensure nothing important is left out. At the end of the day, a good allocation is one that brings you closer to making better decisions and not just balancing figures in a system.