Activity-Based Costing (ABC)

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Activity-Based Costing (ABC) - Page 2 of 2

The analysis of activities of a company starts with identifying which activities will be covered by the analysis. Experts recommend the analysis of at least half a dozen organizational units with a common functional orientation to start the program. The analysis of each activity includes, among other things, determining the following: 1) whether it is value-adding or non-value-adding; 2) whether it is primary or secondary; and 3) whether it is absolutely required or not (discretionary).

As discussed earlier, value-adding activities contribute something of 'value' directly to the manufacture of the products or rendering of the services sold to the customer, while non-value-adding activities do not. Primary activities directly support the company's mission while secondary activities simply support the primary activities. Required activities need to be performed all the time, while discretionary activities are those that are only performed if allowed by management.

Cost data gathering involves the determination of the costs incurred by the activities being analyzed. These costs include salaries of the people performing the activities, material costs, equipment and furniture costs, and even R&D costs. Actual cost data are preferred but if they're unavailable, estimates based on cost formulas may be used.

The tracing of costs to activities refers to the process of determining where the total cost of each output comes from. Every output of an organization was produced by one or more activities, each of which incurred costs when undertaken. This step aims to determine where the costs are being incurred in producing an output, by determining which activities are needed to produce that output and what costs are incurred in each of these activities.

The establishment of output metrics pertains to determining the total cost of producing an output. It consists of the calculation of the actual activity unit cost for each primary activity and the generation of the bill of activities. The activity unit cost of an activity is the total input cost divided by the primary activity output volume. The total input cost should include both the costs incurred by the primary activity and its associated secondary activities. The bill of activities is the list of activities (and their corresponding consumed amounts) needed to produce the output. The total cost of the bill of activities is the sum of each activity unit cost multiplied by its corresponding activity amount consumed.

The analysis of costs is the step wherein the activity unit costs and bills of activities are analyzed to identify areas for further improvement in the companies' business processes. This is where non-value added activities are properly identified for elimination, resulting in better business performance and greater efficiency.

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Primary References: http://www.faa.gov; Des Dearlove, "Ultimate Book of Business Thinking", Capstone Publishing

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