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Learn the ins and outs of activity-based costing

Activity-based costing (ABC) helps you understand the profitability of all product lines. Here's how ABC may benefit you.

The power of activity-based costing (ABC) is the ability to understand the profitability of each product line. If the direct costs and indirect costs are few in number, ABC may not be required. Or if management believes it has a firm grip on costs by product line, ABC is unlikely to help. But if companies are seeking better tools to manage profitability, especially on the cost side, ABC may be required.

Let's look at what comprises ABC, at a hypothetical example and at how you can begin using ABC.

ABC is based on a set of fairly simple premises: profitability, which drives corporate success, and margin (revenue minus cost), which is the accounting definition of profitability. Profitability increases with increased sales of products or services, as long as costs are less than sales revenue. Profitability also increases with flat sales, but at reduced costs. Margin must be calculated for a variety of products and services sold by the company. Revenue is easy to calculate. Cost is not.

Calculate cost in two parts in activity-based costing

1. Activities -- Activities are required for the creation of products or services. An activity is any business process that contributes to the creation of a product or service. If you are creating appliances, for example, one activity would be manufacturing. A second activity might be a series of advertising campaigns. Understanding cost requires a thorough understanding of activities that contribute to preparing a product to be sold (and selling it).

2. Resources -- Activities require resources and resources have costs. Some costs are directly associated with a product, like the manufacturing of an appliance. Other costs are indirect, like advertising, and must be allocated across a large number of appliances.

The cost of an activity is equal to the cost of all resources consumed by the activity. The cost of a product or service is equal to the sum of all the activities required to create the product or service.

An example of activity-based costing

Many large cities build concert halls to provide entertainment for local residents and tourists. During the concert season, activities include booking talent, creating a concert calendar, selling tickets, and creating promotions through advertising and the press. Let's consider this venture from an ABC point of view.

Products. A different concert is held each night. Some are individual performers, some are full orchestras. Each requires a set of activities to ensure the concert goes off without a hitch. If the calendar consists of 100 events, each concert is treated as a separate product.

Activities. Here are some of the activities needed and their associated resource costs:

  • Negotiate fees paid to artists. The fee is a direct cost.
  • Manage transportation, hotels and other logistics. Again, the associated costs are direct costs, related to the concert itself.
  • Maintain staff to negotiate with artists. These staff costs are indirect costs, allocated over multiple concerts (products).
  • Run the box office. Staff costs are indirect costs.
  • Maintain a website to allow Web-based purchasing and to maintain the seat plan for the concert. The creation and maintenance of this website is an IT cost (indirect).
  • Manage advertising and public relations. Again, an indirect cost.

Pointers for implementing activity-based costing

To begin using ABC, consider working with a single product line or a number of products within one line of business. In this way, the work can be handled easily with a small database, joined to a spreadsheet. The key will be to document products, activities and resources (with their costs). The analysis should show the "new" costs and profitability by product line. If there are significant insights here, an ABC automation project may be required.

If you are running ERP software, it is likely that your ERP vendor offers an ABC module. This can make the overall implementation and integration process simpler.

If you are running enterprise performance management software, your EPM vendor may have ABC offerings (or partners). EPM vendors that offer ABC include SAP, Oracle, SAS and Tagetik.

You can also learn a lot from targeted ABC cost management vendors, including Acorn Systems, proDaCapo and QPR CostControl. You might also consider working with your accounting firm. Larger firms have a methodology and consulting offerings in ABC.

Software vendors should provide a comprehensive methodology and a straightforward approach to mapping costs from the accounting system to ABC. The redefinition of indirect costs will be especially important. Finally, what-if analysis and report writing are critical to providing management with the true profitability of products or services by product and channel, which can then lead to strategic changes in product and market strategy.

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