Activity-Based Costing (ABC)

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Activity-based Costing (ABC) is a dynamic and systematic accounting methodology for realistically calculating the actual cost of doing business, regardless of organizational structure. ABC originated from the efforts of Dr. Robert Kaplan of Harvard, who also conceptualized the Balanced Scorecard.

Activity-based costing involves the creation of models of the actual costs incurred by a company at each stage of its core processes. In fact, a cost is attached to every activity, such that the cost of executing each activity may built into the cost of producing the products or services offered by the company. As a result, the cost contribution of each activity to the total cost incurred by the company to manufacture its goods or render its services is determined, and a better understanding of the company's cost structures is achieved. The drawback of implementing ABC is that it requires time and resources to implement it properly.

Proponents of ABC believe that the major thrusts of a company such as continuous process improvement and simplification to boost productivity can only be attained if the real cost and time required to produce its goods and services is determined. This will prevent indiscriminate cost-cutting measures (such as miscalculated downsizing) that may actually result in worse performance and profitability.

An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services. An activity consumes resources as it transforms its inputs into outputs, and therefore incurs a 'cost' every time it occurs. Allowing an organization, or even every employee involved, to understand the cost of doing each activity gives it a better chance to perform the activity better while minimizing costs. In fact, the cost attached to an activity may be used as a metric for organizational or personnel performance.

ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either 'value-added' or 'non-value-added.' Value-added activities are activities that add value to the product or service that the customer is willing to pay for. Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities. On the other hand, non-value-added activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn't really want to pay for. Staging of products and unnecessary inspection are examples of non-value-added activities. Non-value added activities, in general, must be eliminated if possible.

Activity-based costing consists of the following steps: 1) analysis of activities; 2) cost data gathering; 3) tracing of costs to activities; 4) establishment of output metrics; and 5) cost analysis.

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