An introduction to
concepts of Activity Based Costing

By J. Carlton Collins, CPA

Whether you believe it or not, the way you measure your company affects your company. In the United States we measure profitability, and as a result, much of our efforts are centered around maximizing profitability. In Japan, the focus is on market share, and as a result Japanese companies will go to great lengths and expense in order to gain market share. For example, a Japanese company may break even one year, but if the market share increases by a fraction of a percentage, then the company celebrates. Under communism, companies in Russia measured themselves based on materials consumed. The general idea is that if more materials are consumed, then more Russians are employed mining or harvesting those raw materials, packaging those raw materials, or transporting those raw materials, etc. Reportedly one Russian company was honored for doubling it’s consumption of raw materials. The company made camping gear and when an engineer redesigned the gear to be twice as thick, the company ended up selling about the same amount of gear, but because more raw materials were consumed in the process, the results were considered a success. Meanwhile, Russians are hiking around with twice as much weight on their backs.

My point is that measurement does have an impact on results. If you measure your employees based on hours worked, they will most likely work longer hours. If you measure them on new customer sales, they will most likely work harder to generate new customer sales. Here in the United States, we rely on a measurement concept called “Historical Cost Accounting”. When consistently applied across the country, this standard does help Wall Street to compare one company to another to a certain degree. However “Historical Cost Accounting” is severely flawed because it usually does not reflect reality. For example, today it is common to see a company value land on their balance sheet at $1 million even though it is worth $50 million or more. Similarly, our depreciation and amortization standards often do not reflect reality as well.

So what is the answer? Many experts believe that the best method for measuring a business may be "Activity Based Costing". Some accounting software products such as SAP, Syspro IMPACT Encore, and Deltek offer strong ABC accounting. This method is described and discussed below.

Activity Based Costing (ABC) Defined - Activity Based Costing is a method for estimating costs for specific activities within the organization. For example, a contractor may be interested in determining how much it costs one work crew to install shingles on a house compared to a different work crew. Or, the contractor may be interested in determining how much it costs to install shingles on a certain house design, compared to a different house design.

To better understand Activity Based Costing it is sometimes helpful to think in terms of subdivided a project into discrete, quantifiable activities or phases. The activity needs to be definable where productivity can be measured in units (e.g., number of hours work compared to units produced, square footage completed, or volume generated, etc).

As the project is segmented into its activities, a cost estimate is typically prepared for each activity. These cost estimates will typically contain labor, materials, equipment, and subcontracting costs, including overhead, for each activity. Each activity cost estimate is added to the others to produce an overall cost estimate for the entire project.

How Activity Based Costing is Applied

The results generated by Activity Based Costing methods are frequently used to produce reasonable standards on which future estimates can be calculated. For example, for years construction firms and industry trade groups have collected cost data on a wide array of construction projects. The amount of hours associated with those costs were also collected. As an example, this data included the cost of the paint, labor, equipment, and overhead to paint a room, the amount of surface area painted, and the manpower required to paint the room. This practice has allowed contractors to calculate a cost per area and manpower per area. These costs are based on an activity, such as painting, and are known as ABC.

Activity Based Costing methods are also used to evaluate specific activities within an organization to determine whether those activities are being conducted efficiently, whether those activities are necessary, whether other groups within your organization are performing those activities better than others, whether certain materials or tools help your organization complete those activities more efficiently, etc. 

For more detailed information on Activity Based Costing, you might find the following link helpful: http://www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf