Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each. It also assigns more indirect costs (overhead) into direct costs. In business organization, the ABC methodology assigns an organization’s resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability.
As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. Activity based costing first introduced in 1987, by Robert Kaplan and Robin Cooper as a chapter in their book Accounting and Management: a Field Study Perspective. Kaplan and Cooper’s focus was on manufacturing environments where increasing technology and productivity improvements have decreased the percentage of costs represented by direct labor and materials (Weiner). Traditionally cost accountants had arbitrarily added a broad percentage of expenses into the direct costs to allow for the indirect costs,” states Robert Kaplan, a Baker Foundation Professor at Harvard Business School. However as the percentages of indirect or overhead costs rise, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. Instead of using broad arbitrary percentages to allocate costs, the ABC model seeks to identify cause and affect relationships to objectively assign costs.
Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. This way ABC identifies areas of high overhead costs per unit and directs attention to finding ways to reduce the costs (Kaplan). The Computer Aided Manufacturing-International defines Activity Based Costing as “… the collection of financial and operation performance information tracing the significant activities of the firm to product costs. The key is that activities are traced to costs, not vice versa. It is not assumed that just because a cost was incurred it was necessary. It follows then that products and customers consume resources which must be measured, as opposed to simply allocating incurred costs against actual activity levels (Weiner).
Activity based costing is best used when the transaction process takes place on a regular basis. This includes most branch activities (deposits, withdrawals; payments, new and closed accounts and loans, money orders, etc. and most office operations functions (proof, transit, bookkeeping, statement rendering, loan payment processing, etc. ). ABC is best applied to those functions and activities that have easily identifiable units of measure and capacity (Kaplan). In summary, activity based costing is one component of the overall profitability measurement process, which includes funds transfer pricing, capital allocation and performance measurement.
It can be successfully applied in financial institutions, although primarily in transaction processing areas. It is also useful tool to better measure the resources that are consumed in the process of delivering products to customers.
Kaplan, Robert S. “Rethinking Activity-Based Costing. ” HBSWEEK. 2005. Harvard Business School. Web. 5 Oct. 2009 Weiner, Jerry. “Activity Based Costing for Financial Institutions. ” BNET. 1995. The Journal of Bank Cost & Management Accounting. Web. 5 Oct. 2009.