The purpose of ABC is to more accurately define the overhead and/or indirect costs associated with the manufacturing process and apply those costs to the product. It enables you to know exactly how much time and materials go into a product from all areas instead of just the ones that are obvious of great value to any organization. It leads to more efficient processing in the manufacturing process, which in turn leads to greater profits through realization of cost savings.
In the past, cost accountants would add a percentage of expenses into direct costs as an allowance for indirect costs. (Wikipedia.org) With the advent of ABC, expenses are now more accurately defined and added to product lines appropriately. Although the process to define these expenses is sometimes tedious and costly, for some companies it provides an invaluable tool with which to measure the profitability of a product.
According to the OSD Comptroller iCenter website, which provides financial services information for the Department of Defense, there are four steps to ABC implementation:
- Identify activities—perform an in-depth analysis of the operating processes of each responsibility segment. Each process may consist of one or more activities required by outputs.
- Assign resource costa activities—thiis sometimes called “tracing.” Traceability refers to tracing costs to cost objects to determine why costs were incurred. DoD categorizes costs in three ways:
- Direct—costs that can be traced directly to one output. Example: the material costs (varnish, wood, paint) to build a chair.
- Indirect—costs that cannot be allocated to an individual output; in other words, they benefit two or more outputs, but not all outputs. Examples: maintenance costs for the saws that cut the wood, storage costs, other construction materials, and quality assurance.)
- General & Administrative—costs that cannot reasonable be associated with any particular product or service produced (overhead).
These costs would remain the same no matter what output the activity produced. Examples: salaries of personnel in purchasing department, depreciation on equipment, and plant security.
- Identify outputs—identify all of the outputs for which an activity segment performs activities and consumes resources. Outputs can be products, services, or customers (persons or entities to whom a federal agency is required to provide goods or services).
- Assign activity costs to outputs—assign activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs’ consumption or demand for activities. For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver). (OSD Comptroller iCenter)
As we can see the methodology behind Activity-Based Costing is sound, and can result in sometimes great savings to a company willing to take the time, effort and expense to implement a plan