Activity Based Costing System Case Study

Implementing Activity-Based Costing in the Telecommunications Sector: A Case Study

Maria Joao Major*

Associate Professor of Management Accounting at ISCTE – University Institute of Lisbon and BRU/UNIDE researcher, Avenida das Forças Armadas, ISCTE-IUL, 1649- 026 Lisbon, Portugal

*Corresponding Author:
Maria Joao Major
Associate Professor of Management Accounting at ISCTE–University
Institute of Lisbon and BRU/UNIDE researcher
Avenida das Forças Armadas
ISCTE-IUL, 1649-026 Lisbon, Portugal
Tel: 351/217903495
E-mail:[email protected]

Received date: November 28, 2013; Accepted date: December 30, 2013; Published date: January 06, 2014

Citation: Major MJ (2014) Implementing Activity-Based Costing in the Telecommunications Sector: A Case Study. J Telecommun Syst Manage 3:111. doi: 10.4172/2167-0919.1000111

Copyright: © 2014 Major MJ. This is an open-access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.

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Abstract

Profound changes have affected the European telecommunications sector in the last 15 years. With its liberalization at the end of 1990s many telecommunications companies, such as International Telecom had to adopt advanced managerial accounting systems that could provide them with detailed and accurate cost accounting information. To this respect Activity-based Costing revealed crucial to aid International Telecom to face fierce competition coming out from the new operators that came into market and to respond to regulatory demands.

Keywords

European telecommunications; Activity-based Costing; Managerial Accounting

Introduction

This paper aims to investigate how the introduction of competition into the EU telecommunications market affected the development of managerial accounting systems in a specific company called ‘International Telecom’1. ‘International Telecom’ was established in the beginning of 1900s to provide telegraphic radio communications. Since then the company has the long distance telecommunications services as its core business. Until the liberalisation of the EU telecommunications sector ‘International Telecom’ operated in a monopoly regime. This made it a very profitable company. Yet the introduction of competition into the sector in 2000 led to a decrease in ‘International Telecom’s’ turnover, margins, and profits, which pressured it into initiating a full programme of change. This programme of change included: (i) revision of its strategic plan; (ii) adoption of strategic control benchmarks; (iii) implementation of a new career evaluation system; (iv) adoption of EIS – Executive Information Systems to provide senior managers with operational and strategic information; (v) introduction of SAP; and (vi) replacement of ‘International Telecom’s’ previous managerial accounting system by activity-based costing (ABC). Of all the managerial projects introduced, the adoption of ABC was the major one, not only in terms of human and financial resources allocated but also by the time and importance managers attached to the project. ABC was adopted by ‘International Telecom’ as a management tool to assist managers reducing costs and improving competitiveness (see Jones and Dugdale, 2002 who discuss the relevance of ABC). The adoption of a modern and sophisticated managerial accounting system, such as ABC, was needed to assure public opinion, including the regulators and the new operators in the market, that costs were calculated based on a rational and reliable system, and furthermore that ‘International Telecom’ was making serious efforts to improve its performance.The paper is structured as follows: section two describes ‘International Telecom’s’ managerial accounting system before the liberalisation of the EU telecommunications market; section three discusses how ABC was implemented and how it operates; the paper ends with the presentation of conclusions in section four.

‘International Telecom’s’ managerial accounting system before liberalisation

When ‘International Telecom’s’ managers were faced with the prospect of competition being introduced in the EU telecommunications market[1,2] they were not concerned in having a very sophisticated managerial accounting system yet cost objects were already identified. Direct costs were calculated for each of these cost objects, and indirect costs were allocated proportionally to the amount of direct costs. Direct costs were the most important element in total costs, representing 70% on average of total costs. It was decided that cost objects should be the products and services the company was providing. Those were: (1) automatic international fixed phone calls (for Europe, US, Canada, Central America, Brazil, South America, Angola, South Africa, other African countries and Asia); (2) ‘International Telecom’ Phone Card; (3) International ‘Green Calls’; (4) Virtual Private Network; (5) Country Direct; (6) Value Added Services; (7) Semi-Automatic Calls; (8) Intercontinental Telex; (9) International Telegraphy Services; (10) Data Communication; (11) Store & Forward Fax; (12) TV; (13) Radio; (14) Video-Communications; (15) Les/Inmarsat C; (16) Leased Circuits; (17) TCR; (18) Restoring; (19) Leased Capacities and (20) Engineering Services.

Direct costs were identified as follows: (1) traffic costs (i.e. the costs ‘International Telecom’ supports for using the telecommunications capacities of international operators and correspondents); (2) leased capacities (costs of getting basic transport infrastructure to wholesale and retail services); (3) transmission costs (costs that ‘International Telecom’ supports for using its own systems of submarine cables, satellite, radio, and network); (4) commutation costs (costs of managing the network); (5) other costs of operation (including costs of activities such as engineering, maintenance, management and control, planning, computer systems, training services etc., when these are developed for specific products/services; (6) commercial costs (marketing costs, and other costs related to the commercial function when concerned with specific products/services); and (7) direct costs of capital (costs of capital of the specific fixed assets used to obtain products/services).

Indirect costs were on average roughly 30% of total costs and comprised the following items: (1) costs of capital not specific to any fixed asset used to obtain products/services; (2) costs of activities not directly associated with cost objects; (3) costs of transmission of systems whose capacity was not used; and (4) costs generated by staff departments and costs of macro-structure. Exhibit 1 shows a typical Income Statement prepared for cost accounting reports by ‘International Telecom’s’ management accountants before the adoption of ABC.

Cost accounting reports were prepared by the Finance and Administration Department every quarter, half-year and year. These reports had two parts. The first part provided an income statement for the whole of ‘International Telecom’, followed by comments and analysis of each main cost/profit item. These comments and analyses would usually not exceed 12 pages. In the second part, income statements were presented by cost object. These reports were prepared basically for the Board of Directors and the managers of the different departments of the company. A standard costing system was used: standard costs were compared with actual costs, and variances were calculated periodically. These variances were used as information for managers, and not for assessments of managerial performance. Cost standards were updated annually. However, by 1996, the existing managerial accounting system was no longer satisfying the costing needs of the company. In 1997 ‘International Telecom’ abandoned this costing system and replaced it with ABC

Activity-based costing adoption

ABC implementation was strongly supported from the beginning by ‘International Telecom’s’ Board of Directors. The Board of Directors had a consensus about the importance of implementing ABC, which facilitated its implementation. Substantial material resources, including time and personnel, were allocated to the project. Due to competitive pressures, the information needs of commercial departments (Consumer Markets Department and Carrier Services & Network Planning Department), together with those imposed by regulators, were identified as a priority. ‘International Telecom’ began the process of ABC implementation with external consultants in July 1997. The consultants and ‘International Telecom’s’ management accountants decided to adopt a full installation strategy and to implement ABC throughout the whole organisation [3,4].They also decided that in a first phase the ABC system should operate simultaneously with the ‘old’ managerial accounting system, and that after a short test period it should replace the previous system. Additionally, it was planned that ABC would be integrated with financial accounting. Finally, they devised an ABC system to report historical costs.

The consultants took six main steps to implement ABC: (1) selection of teams; (2) team training; (3) definition of activities; (4) definition of the conceptual model; (5) collection of data, and (6) definition of the ABC software. Exhibit 2 traces these six steps over time (Exhibit 2).

In July 1997, teams were selected and trained. From July to September, activities were identified. The ABC model was devised in September. Inputs of ABC and data were obtained from September to December 1997. In December, the software to support the ABC system was chosen. In March 1998, the 1997 accounts were provided by ABC. The consultants formed two committees to support the ABC implementation process. The first consisted of the general finance director and the directors of operational areas (the Finance and Administration, Planning and Control, Consumer Markets, Carrier Services, Telecommunications Infrastructure, and Development and Information Systems departments). The second committee consisted of those responsible for implementing ABC, i.e. the consultants, ‘International Telecom’s’ management accountants, and representatives of the commercial and production departments. According to the consultants, the idea was for ownership of the system to be shared by all operational departments, and not just the Finance and Administration Department.

After the personnel to implement ABC had been selected, training programmes were held. They discussed: (1) the design of the ABC model; (2) the objectives behind ABC implementation; and (3) the ABC implementation process. These meetings were directed exclusively at the committee members. It was believed that due to the strategic nature of the ABC system, only those directly involved with the project should shape its objectives and features. The workers were not consulted about the implementation of a new ‘managers’ tool’, although this tool was going to require some participation by them in feeding ABC. Every three months, all ‘International Telecom’s’ employees2 have to allocate their time to the activities identified within the ABC system for resource costs to be allocated to activities. This process is supported by the completion of time sheets in Excel. Consultants and management accountants called this process ‘PMO’3 [5].

The training meetings were followed by the definition of activities. Before specifying activities, the consultants first identified functions and processes for the whole organisation [3]. This was done with the help of the management accountants. Interviews with employees were then conducted in order to obtain information about the activities performed. People’s description of their jobs were obtained, analysed and compared with one another, so that subsequent activities could be identified across organisational boundaries. Work distribution charts were produced summarising the activities performed by employees in each department. Simultaneously, employees were asked about the total time spent on each activity. This helped the consultants to identify activities more accurately [6]. Flow charts were drawn up for each activity performed in ‘International Telecom’. Inputs and outputs among activities within the same business process were linked and graphically represented.‘International Telecom’s’ old managerial and cost accounting system had already defined some activities, but they were incompatible with the concept of activity for ABC - i.e. a homogeneous set of tasks and operations transversal to the organisation. The earlier definition did not cross departmental boundaries, and comprised a very wide range of actions. Nevertheless, the activities defined before helped the consultants to define the activities of the new managerial accounting system. In the old managerial accounting system, some indirect costs were already allocated to products/services through activities. Even though the activities defined before were not very detailed, the existence of a previous system helped the consultants to implement ABC swiftly. The old managerial accounting system was particularly useful for the consultants in the allocation of resource costs to systems in the operational centres. Some costs incurred in these centres were imputed to submarine cables, satellites and commutation, based on the number of hours performed by employees directly operating these systems. This procedure was maintained by the consultants in the new managerial accounting system.The identification of activities was seen as a very important step in the implementation of ABC by the consultants and management accountants. They were therefore involved for three whole months in disaggregating functions and business processes in activities. In order to facilitate the definition of activities, cost objects were identified. In the definition of cost objects, ‘International Telecom’s’ business segments were analysed. It was concluded that the international telecommunication services comprised five business segments: (1) fixed telephone; (2) telematics (which include telex, telegraphy, data communication, and store & forward fax); (3) leased capacity (which embrace MID - Direct Ethernet, broadcasting – videocommunications, TV and radio - restoring, and leased circuits); (4) alliances with other operators (as for example with Concert); and (5) other segments (which contain communications through satellite, Inmarsat-C, TCR – telemetry, engineering services in cables and international projects).

After the consultants and management accountants had identified the main priorities of ABC, they decided to calculate costs in five areas: (1) systems (including submarine and terrestrial cables, and satellites. Examples of systems are: Eurafrica; Tagide; Ariane; Columbus; and Americas); (2) tracks (i.e. the path established between operators to support communication. ‘‘International Telecom’ – British Telecom’, and ‘France Telecom – AT&T’ are two examples of tracks); (3) tracks by services and carriers (e.g. British Telecom-Fixed Phones, etc.); (4) carrier (e.g. France Telecom; AT&T; Telkom South Africa; British Telecom, etc.); and (5) Products/Services. The calculation of costs for the first four areas is easily obtained after calculating costs of products and services, since the latter dimension involves information about the costs of systems, tracks and carriers.

During the identification of activities and the definition of cost objects, the consultants were able to collect the information needed. The consultants believed that all areas were co-operative in providing data, though the two commercial departments (the Consumer Markets Department and Carrier Services & the Network Planning Department) were the most involved. A dictionary of activities was prepared that defined the scope of each activity. In the dictionary, each activity is named and a short statement of roughly five lines defined it. The aim was to produce a definition of activities that was consistent across the people concerned. The dictionary of activities was particularly useful when people need to complete the PMO [4]. It was distributed to all directors and managers involved in developing ABC who were accountable for explaining the scope of activities to employees if doubts were raised. After defining ‘International Telecom’s’ main functions, processes and activities, the consultants began identifying cost drivers.

Before, cost drivers were not used to allocate costs to products because activities’ costs were imputed to products/services only when they were directly associated with cost objects. The costs of activities not directly related to products/services were registered as indirect costs in the income statement. Direct costs were used as the allocation basis for allocating indirect costs to cost objects. In the new managerial accounting system, on the other hand, cost drivers were defined. Their definition was dependent on the feasibility of obtaining data to support their calculation. After inquiring about the drivers that could enhance the causal relationship between the cost of activities and products/ services, and the availability of information to make calculations, the consultants chose ten drivers.

The next step, after the identification of activities and cost drivers, was the construction of the conceptual model. The architecture of the system was devised by an overseas consultant who was called in at this stage to provide support, due to his experience and knowledge of the telecommunications industry. It was decided with the Board of Directors that the ABC system should be oriented mainly to the commercial areas, and that the production department would be the main department feeding the system [5]. In September 1997, the data collection process began. In December 1997, after writing the software to support the ABC system, the company was able to generate the first outputs from ABC. The cost data for the first semester of 1997 was obtained, and then discussed by the managers involved in the ABC implementation process. Oros was chosen as the most appropriate computer software to support ABC. Before changing its managerial accounting system to an ABC model, ‘International Telecom’ was using the Millennium computer system. It was decided that an SAP application should replace the Millennium system. ‘International Telecom’s’ ABC implementation took about nine months, during which the consultants were in the company on a daily basis. Managers was aware from the beginning of the heavy costs of implementing ABC, so they decided to ‘learn’ as much as possible about how to operate the ABC system from the consultants. This attitude seemed to be supported by the consultants, who were apparently committed to transferring all the know-how needed for ‘International Telecom’ to work the system.

The ABC system implemented in ‘International Telecom’ is relatively complex. This is because the new managerial accounting system had to provide cost data to regulators, whilst giving managers sound economic information to support pricing and investment decisions and outsourcing strategies. ‘International Telecom’s’ ABC system comprises 115 activities, 71 of which are main activities and 44 supporting ones. The main activities consist of activities oriented to customers (35 activities) and to the network (36 activities). Table 1 briefly describes these activities4 (Table 1).

Activities:
1) Main Activities
1.1) Activities Oriented to Customers
• Defining strategies in Telecommunications business
• Researching and analysing new business opportunities
• Elaborating and controlling marketing plan
• Researching markets and customers
• Developing products and services
• Commercialising products and services
• Billing
• Management of customers’ debts
• Maintenance of customers’ services
• Assuring the quality of services
1.2) Activities Oriented to Network
• Following telecommunications network technology trend
• Planning network telecommunications
• Managing telecommunications technology development
• Developing and implementing telecommunications network
• Managing the use of network resources
• Operating traffic
• Operating infrastructures
• Restoring telecommunications network
• Preventive maintenance
• Corrective maintenance
2) Supporting Activities
• Developing and managing human resources
• Managing internal communication and information
• Managing financial and physical resources
• Managing the image and the firm’s external relations
• Legal support

Source: ‘International Telecom’s’ Dictionary of Activities.

Table 1: ‘International Telecom’s’ ABC Activities.

‘International Telecom’ adopted labour hours as first stage drivers, i.e. drivers of resources. The costs of each department are allocated to activities based upon the disclosure of employees’ time by activity (PMO). Thus, information provided by employees is crucial to enable the calculation of the cost of activities in ‘International Telecom’s ABC system. After the allocation of resource costs to activities, the cost of the latter is attributed to equipment’s, systems, tracks, carriers and product/services when related with them. Second–stage drivers (i.e. activity drivers) are used in this allocation process. When activities costs are not related with any of these cost objects, costs are classified as ‘common costs’5 in the income statement. Exhibit 3 shows ‘International Telecom’s’ ABC architecture, and Table 2 lists the second stage drivers, i.e. drivers of activities, selected by the consultants and management accountants ( Exhibit 3 and Table 2).

 Description
Driver 1Number of invoices valued by effort
Driver 2Number of documents (incoming traffic) * 80% + number of open positions > 6 months * 20%
Driver 3Number of invoices per product/service
Driver 4Number of invoices * 70% + number of open positions > 6 months * 30%
Driver 5Setups (Broadcasting – accidental services)
Driver 6Number of processes valued by duration
Driver 7Number of alterations in network valued by the type of service
Driver 8Tracks valued by number of circuits
Driver 9Similar allocation for the respective pseudo-department
Driver 10Reallocation according to computer applications/machines DDS

Source: Finance and Administration Department – ‘International Telecom’.

Table 2: Drivers of Activities.

In the new managerial accounting system, direct costs are basically the same as those identified in the previous system. Thus the cost items of ‘traffic’ (now called costs of ‘operator’), ‘transmission’, ‘commutation’, ‘leased capacities’, and rent are maintained. The other direct costs that are new in are the costs resulting from the allocation of activities to cost objects, following ABC implementation. In the present managerial accounting system, direct costs are roughly 75% of total costs, whereas they were formerly about 70% of total costs. In 1997, indirect costs were identified as embracing joint costs and common costs. Joint costs are not significant in ‘International Telecom’s’ costs structure. They represented approximately 2.5% of total costs in 1999. Joint costs include joint costs of products, joint costs of carriers (costs of carrying traffic for a range of products/services), and the costs of capacity of transmission systems and commutation, which were made available but were not used. Finally, common costs include the costs that the ABC system could not trace directly to cost objects. In 1999, they were about 22.5% of total costs. Common costs comprise the following items: (1) costs of activities not directly associated with cost objects (or with a family of products); (2) costs of supporting activities which cannot be reallocated to primary activities; (3) costs of capital of the fixed assets that are not directly related to products/services; (4) remunerations and fringe benefits of the Board of Directors, and of personnel temporarily transferred to the telecoms operating in the market; (5) depreciations of fixed assets not directly associated with cost objects (e.g. equipment used by the Board of Directors, telecommunications systems that are not in use, etc.); and (6) extraordinary costs.

Exhibit 4 presents the format of the income statement used in the ABC System (Exhibit 4).

The income statement presented above is used to present cost data for: (1) fixed telephone (coming in, in transit and going out) to European countries, US, Canada, Central America, South America, South Africa, Angola, other African countries, and Eastern countries); (2) ‘‘International Telecom’s’ Green Line’; (3) telematics – telex, telegraphy, fax and data; (4) leased capacity – national, broadcasting, MID, leased circuits, restoring; (5) Inmarsat-C; (6) TCR; and (7) other products/services.

Other income statements that emphasise systems and activities may also be prepared. Their format is similar to that presented above, except that systems and activities are exhaustively listed below lines 2.4.1. to 2.4.4., and 2.6.1. to 2.6.2. of the income statement, respectively.

ABC data was included in an EIS – Executive Information System. When EIS was introduced in ‘International Telecom’ it was intended to include only aggregated cost data from the new managerial accounting system. However, because there was no system that could systematically distribute detailed ABC data (except for special reports commissioned by managers), it was decided to provide exhaustive cost data to managers through EIS. In order to facilitate the use of ABC data by all departments, and simultaneously to enhance enthusiasm for the new system in 2000, the management accountants decided to continue preparing managerial accounting reports on an annual basis, as they had done before. The reports management accountants prepare these days comprise: (1) an executive summary of the most relevant events that occurred in ‘International Telecom’ and its business environment; (2) the presentation of income statements for the whole company, reporting costs/profits for the year in analysis and the previous year; (3) a detailed analysis of each cost item included in the income statement and a comparison with its amount in the previous year. This analysis includes: (a) the presentation of tables reporting the costs of activities by department; (b) profits and costs of automatic telephone by traffic coming in, in transit and coming out; (c) costs of systems (satellites, and submarine cables); (d) costs of commutation and networks; (e) costs of tracks and carriers, amongst other elements; and (4) conclusions.

Conclusion

The telecommunications industry nowadays operates in a highly competitive market; with the full introduction of competition into the European telecommunications sector, ‘International Telecom’ has faced huge pressures to improve its competitiveness [2,7]. Its business activities were redefined and focused exclusively on providing international telecommunications, its organisational structure was altered, and its managerial accounting was changed.

‘International Telecom’s’ managers felt that their information systems were not appropriate for the new challenges of the telecommunications market, and that more detailed and accurate costing data was needed. This brought several changes: SAP replaced Millennium; special informational systems directed at executives, such as EIS, were introduced; and ABC was implemented, amongst other changes.

Firms that are concessionaires for public telecommunications services (and thus accountable for the telecommunications universal service), and are dominant within the market, as is ‘International Telecoms’, are exposed to a high level of institutional demands [5,8]. These demands are manifest in the requirement for ‘International Telecom’ to provide detailed information about the quality and the cost of the services and products it provides [5]. Some of the pressures exerted by the regulator and the European Union are related to their need to satisfy market and public opinion that both the ‘old’ and the ‘new’ telecommunications firms operate under equal conditions, and that ‘true’ competition has been introduced [9,10].

‘International Telecom’ adopted ABC not just for generating costing data to assist managers, but also to respond to legal-institutional obligations to provide exhaustive and structured costing data, at any time. The adoption of ABC enabled the company to legitimise its pricing practices, particularly within the leased circuit and fixed telephone services and interconnection businesses to the regulator and the general public. At the same time, ABC met the demands of managers seeking managerial tools to help them meet the challenges posed by the full introduction of competition. In sum, the adoption of ABC fulfilled expectations for modernisation in ‘International Telecom’, created by the reorganisation of EU telecommunications sector.

1A disguised name is used in the paper to cover up the real identity of the company.

2This includes managers: only the Board of Directors is exempted from this task.

3PMO means ‘labour time disclosure’.

4These activities are sub-divided into more detailed activities, which have not been included here for reasons of convenience.

5In a rare number of cases, there are additional costs of activities that are caused by a family of products/services. In this case, the costs of these activities are included in the loss and profit account as ‘joint costs of products’, thereby being excluded from common costs. This is the case of the costs incurred in the promotion of a whole family of products (e.g. fixed phone).

References

  1. Arthur Andersen (1997) Accounting separation in the context of open network provision, Draft Guidelines Prepared for DG XIII of the European Commission.
  2. Bromwich M, Hong C (2000) Costs and regulation in the U.K. telecommunications industry, Management Accounting Research 11: 137-165.
  3. Cooper R (1990) ‘Implementing an activity-based cost system’. Journal of Cost Management (Spring): 33-42.
  4. Major M (2007) “Activity-Based Costing and Management: A Critical Review”, In Hopper, T., Scapens, R. e Northcott, D. (Eds) Issues in Management Accounting Research, 3rd Edition (London: Prentice-Hall) 155-174.
  5. Hopper T, Major M (2007) “Extending Institutional Analysis through Theoretical Triangulation: Regulation and Activity-Based Costing in Portuguese Telecommunications”. The European Accounting Review Vol. 16: 59-97
  6. Major M, Hopper T (2009) “Activity-Based Costing in the Portuguese Telecommunications Industry” In Lee I (Ed) Handbook of Research on Telecommunications Planning and Management for Business, Illinois: Advances in E-Business Research (AEBR) Book Series, (Western Illinois University): 279-292.
  7. Gillett SE, Vogelsang I (Eds) (1999), Competition, Regulation and Convergence: Current Trends in Telecommunications Research (Muhurah, NJ: Lawrence Erblaum Associates).
  8. Kiessling T, Blondeel Y (1998) The EU regulatory framework in telecommunications: A critical analysis. Telecommunications Policy 22: 571-592.
  9. Commission of the European Communities (1998a) Commission Recommendation of 8 January 1998 on Interconnection in a Liberalised Telecommunications Market: Part 1-Interconnection Pricing, Brussels.
  10. Commission of the European Communities (1998b) Commission Recommendation of 8 April 1998 on Interconnection in a Liberalised Telecommunications Market: Part 2-Accounting Separation and Cost Accounting, Brussels.
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What is Activity Based Costing?

Activity based costing ABC is a method for assigning costs to products, services projects, tasks, or acquisitions, based on

  • Activities that go into them.
  • Resources consumed by these activities.

ABC contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional cost accounting can estimate cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when management needs to know exactly which products are profitable and which are selling at a loss.

What Are the Benefits of ABC?

Cost accountants know that traditional cost accounting can hide or distort information on the costs of individual products and services—especially where local cost allocation rules misrepresent actual resource usage. As a result, the move to ABC is usually driven by a need to understand the "true costs" of individual products and services more accurately. Companies implement activity based costing in order to:

  • Identify individual products that are unprofitable.
  • Improve production process efficiency.
  • Price products appropriately, with the help of accurate product cost information.
  • Reveal unnecessary costs that can be eliminated.

Firms that use ABC consistently to pursue these objectives are practicing activity based management ABM.

ABC Impacts the Same Accounts, But With Different Mathematics

Note that the purpose of ABC is to provide information for decision support and planning. ABC by itself usually has little or no impact on the structure of the firm's financial accounting reports (Income statement, Balance sheet, or Cash flow statement). This is because both ABC and traditional costing ultimately assign costs to the same existing accounts. The two approaches simply use different mathematics to do so.

Note especially, however, that ABC sometimes brings improvements in reported margins and profitability. These outcomes follow when ABC reveals unnecessary or inflated costs, or when ABC shows where to adjust pricing models, work flow process, or the product mix.

Explaining Activity Based Costing in Context

This article further defines, explains, and illustrates activity based costing using example calculations to contrast ABC with traditional cost accounting. Examples appear in context with related terms from the fields of budgeting, cost accounting, and financial accounting.


 

Contents

Related Topics

  • For the accountant's role in costing, see the article Accountant.
  • The article Cost Object defines and explains the term "cost object."
  • The article Direct and Indirect Labor Costs further explains the role of these terms in traditional cost accounting.

 

 

Why Do Companies and Organizations Move to ABC?
What are the Reasons for Using Activity Based Costing?

Business people are moved to adopt ABC by a desire to improve costing accuracy, especially to get closer to the true cost and true profitability of individual products and services. And, they also move to ABC in order to understand better the true costs and return on investment from projects, programs, or other initiatives. 

ABC pursues these objectives essentially by making direct costs out of many costs that traditional cost accounting treats as indirect costs. Examples below show how this is done.

Organizations that use ABC consistently and effectively are said to practice activity based management (ABM). Here, management turns to ABC to support decisions about pricing, adding or deleting items from the product portfolio, choosing between outsourcing and in-house production, and evaluating process improvement initiatives. For more on ABM, see the section below "What is activity based management?"

The percentage of organizations currently using activity based costing varies greatly from industry to industry. Various surveys in the period 2012-2017 report the highest percentage of firms using ABC in manufacturing (20%-50%), followed by financial services (15-25%), public sector (12-18%), and communications (6-12%).

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Activity Based Costing vs. Traditional Cost Accounting
What Are the Differences? Do They Lead to Different Costing Results?

The different approaches and outcomes from ABC and traditional costing are easiest to illustrate in the context of a product manufacturing example. However, the principles shown here extend readily to a wide range of other business settings.

Example: Traditional Cost Accounting vs. ABC

For example, consider a firm that manufactures automobile parts through a sequence of machine operations on metal stock. In such settings, traditional accounting views product production costs as either direct costs or indirect costs (or overhead).

Example Sources of Direct Costs

Traditionally, direct costs for such firms are costs they can assign to specific product units. In product manufacturing, these might include direct materials and direct labor costs:

  • Direct labor costs.
    These can include the cost for person minutes or person hours per product unit for running production machines.
  • Direct materials.
    Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants. 

Example Sources of Indirect Costs

Traditionally, indirect costs for such firms are manufacturing overhead costs they cannot assign directly to specific product units. Instead, they allocate these costs to specific production runs, batches, or time periods. These might include indirect costs such as the following:

  • Materials purchase order costs
    Firms typically do not order materials for each product unit, but rather, for entire batch runs. They may also order supply materials to cover a specific time period.
  • Machine set up costs.
    Manufacturing firms do not set up production machines for each product unit. They are set up instead for the production run of each product model.
  • Product packaging costs.
    Manufacturers can sometimes package multiple product units in a single package. And, they may fill multiple packages in a single packaging run.
  • Machine testing and calibration costs.
    Manufacturing firms perform these operations regularly and often, but not for each individual product unit.
  • Machine maintenance and cleaning costs.
    Firms normally perform these operations only after producing multiple product units. 

Product Specific Cost Sources

For this example, consider a firm that manufactures and sells two product models, Model A and Model B. Some aspects of A and B compare as shown in Table 1:

Products ComparedProduct AProduct B
   Selling PriceHigher priceLower price
   Materials purchased More materials purchase orders, smaller ordersFewer materials purchase orders, larger orders
   Production RunsMore production runs, smaller runsFewer production runs, larger runs
  Mach. Set upsMore machine set upsFewer machine set ups
  Packaging1 Unit per package4 Units per package
  Direct laborMore direct labor requiredLess direct labor required
  Direct  materialsHigher direct materials costLower direct materials cost
 Table 1.  Product A and Product B compared.

Direct Costs Are the Same in traditional and Activity Based costing

Management must estimate the profitability of each product in order to decide which products to produce and sell and how to price them. This, in turn, requires an understanding of the full cost per unit of each product. While the direct costs per unit may be found, easily, the indirect costs are less obvious. As a result, the firm will have to uncover product indirect costs through a costing methodology—either traditional cost allocation or activity based costing. 

Direct costs are the same under both traditional costing and ABC. For direct costs, accountants measure a cost per product unit for each direct cost category. The two costing methods differ, however, in the way they assign indirect costs to products. Consequently, the two costing approaches sometimes give quite different pictures of the profitability of individual products. 

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Explaining Traditional Costing
Example Calculations and Costing Results

In one accounting period the firm produces and sells 900,000 units of product A at $3.00 each and 2,100,000 units of product B at $2.00 each.

Traditional Costing: Finding Direct Costs

 Table 2 below shows the resulting revenues and direct costs for these sales.

Products Compared Product AProduct BTotal
1. Units produced & sold900,0002,100,0003,000,000
2. Selling price / unit$3.00$2.00 
3. Direct labor cost / unit$0.50$0.50
4. Direct materials cost / unit$0.75$0.50
5. Sales revenues [ = 1 * 2 ]$2,700,000$4,200,000$6,900,000
Direct costs
6. Direct labor costs [ = 1 * 3 ]$450,000$1,050,000$1,500,000
7. Direct materials costs [ = 1 * 4 ]$675,000$1,050,000$1,725,000
8. Total Direct costs [ = 6 + 7 ]$1,125,000$2,100,000$3,225,000
 Table 2. Sales revenues and direct costs for Products A and B

Traditional Costing: Finding Indirect or Overhead Costs

The company's cost accountants will also find cost totals for the period's production support activities. In traditional cost accounting, these are called "overhead" or "indirect costs," as shown in Table 3 below. 

     Indirect Components

Prod. A & B Indirect% of Total Indirect
Materials purchasing$180,00012.6%
Machine setups$375,00026.4%
Product packaging$280,00019.7%
Machine testing & calibration$300,00021.1%
Machine maintenance & cleaning$287,00020.2%
Total Indirect     $1,422,500100.0%
 Table 3. Indirect cost components for Traditional costing

Traditional Cost Accounting: Calculating Direct and Indirect Costs

The simple form of traditional cost accounting appearing here uses only the total indirect cost line from Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on proportional usage of a given resource. The resource chosen for this purpose is usually one of the direct cost items. Note especially that this approach is also called production volume based (PVB) cost allocation, for obvious reasons.

Under PVB cost allocation, the total indirect cost could be allocated to Products A and B based on factors such as the proportion of total

  • Production machine time used by each product.
  • Direct labor costs used by each product.
  • Factory floor space used by each product.

Other factors may also apply. For this example, the firm's accountants chose to allocate indirect costs referring to direct labor costs. The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product's own direct labor cost:

 Indirect labor cost / direct labor cost proportion:
        = $1,422,500 / $1,500,000 
        = 0.948 = 94.8%
  • For product A, Direct labor costs are $450,00  (Table 2, line 6). The indirect cost allocation for A is therefore 94.8% of this, or $426,750.
  • For product B, Direct labor costs are $1,050,000  (Table 2, line 6). The indirect cost allocation for B is therefore 94.8% of this, or $995,750.

Traditional Costing: Allocating Indirect Costs

Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also shows the traditional costing solutions for gross profit and gross margin for each product unit.

     Products Compared

Product AProduct BTotal
9. Units produced and sold
[Table 2, line 1]
900,0002,100,0003,000,000
10. Total direct costs
[Table 2, line 8]
$1,125,000$2,100,000$3,225,000
11. Total indirect costs
[allocation shown above]
$426,750$995,750$1,422,500
12. Revenues per unit
[Table 2, line 2 ]
$3.00$2.00 
13. Direct costs / unit
[ = 10 / 9 ]
$1.25$1.00
14. Indirect costs / unit
[ = 11 / 9 ]
$0.47$0.47
15. Gross profit / unit
[ = 12 − 13 − 14 ]
$1.28$0.53
16. Gross profit margin
[ = 15 / 12 ]
42.5%26.3%
 Table 4. Gross profit and gross margin calculation for each product, using
 traditional cost accounting approaches for indirect costs.

Conclusions: Traditional Cost Allocation (Product Volume Based Allocation) Example:

  • Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). This must be the case, because indirect costs for both products use the same allocation rate ( 94.8%) applied to direct labor costs, based on the same direct labor rate ($0.50 / unit).
  • On a per unit basis, this traditional costing finds Product A more profitable than product B: The gross margin rate of 42.5% for A compares with a gross margin of 26.3% for B.

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Explaining Activity Based Costing
Example Calculations and Costing Results

This section presents an ABC version of the same product costing situation. The example shows how ABC and traditional costing can yield different indirect cost estimates for the same products. And, this means the two approaches can also estimate profitability differently. Finally, especially, however, that the example also shows clearly that ABC requires more data and more detailed analysis than the PVB allocation approach.

ABC costing for products A and B begins with the same summary table used for the traditional costing example above. Data for starting the analysis includes units produced and sold, sales revenues, and direct costs. The ABC example therefore begins with another copy of Table 2:

Direct Costs Under ABC

Products Compared

Product AProduct BTotal
1. Units produced & sold900,0002,100,0003,000,000
2. Selling price / unit$3.00$2.00 
3. Direct labor cost / unit$0.50$0.50
4. Direct materials cost / unit$0.75$0.50
5. Sales revenues [ = 1 * 2 ]$2,700,000$4,200,000$6,900,000
Direct costs
6. Direct labor costs [ = 1 * 3 ]$450,000$1,050,000$1,500,000
7. Direct materials costs [ = 1 * 4 ]$675,000$1,050,000$1,725,000
8. Total Direct costs [ = 6 + 7 ]$1,125,000$2,100,000$3,225,000
Table 2 (second copy). Sales revenues and direct costs for Products A and B

Overhead or Indirect Costs Under Activity Based Costing

In ABC, the "indirect" or "overhead" cost contributors are viewed as "activity pools."

Under activity based costing, an activity pool is the set of all activities required to complete a task, such as (a) process purchase orders, or (2) perform machine set ups.

In order to "cost"  activity pools, ABC identifies activity units that are cost drivers for each pool. The total cost of for the activity pool "process purchase orders," for instance, is driven by the number of purchase orders processed, while the total cost for activity pool "perform machine set ups" is driven by the number of set ups.

Tables 5A and 5B, below show a cost driver (CD) unit cost for each activity pool: one machine set up, for instance, is found to require $1,500 in labor, materials, energy, and other resources.

Table 5A, moreover, shows the number of CD units (activity units) used for product A, while Table 5B shows these figures for product B. From the known cost of each CD unit, a total cost can be assigned for each product for each activity pool, as the rightmost columns of Tables 5A and 5B show.  

In ABC, assigning cost totals to activity pools in this way, using cost driver units, is  stage-1 allocation, or batch-level allocation

Product A activity units, activity pools, and cost drivers

     Activity Pool

Cost Driver (CD)
Activity Units
CD
Unit Cost
Total Activity
Product A
Total Indir
Cost  (A)
17. Purchase ordersNo of purchase orders$1,80075$135,000
18. Machine set upsNo of setups$1,500150$225,000
19. Product packagingNo of product
packages packed
$0.20900,000$180,000
20. Machine testing
& calibration
No of tests$1001,000$100,000
21. Maintenance 
& cleaning
No of batch runs$1,150200$230,000
Total$870,000
Table 5A. ABC Stage-1 allocation (batch level allocation) for product A: Activity pools, cost drivers, cost per cost driver unit, and total cost for these activities.

Product B activity units, activity pools, and cost drivers 

     Activity Pool

Cost Driver (CD)CD
Unit Cost
Total Activity
Product B
Total Indir
Cost  (B)
17. Purchase ordersNo of purchase orders$1,80025$45,000
18. Machine set ups No of setups$1,500100$150,000
19. Product 
packaging
No of product
packages packed
$0.20500,000$100,000
20. Machine testing
& calibration
No of tests$1002,000$200,000
21. Maintenance  
& cleaning
No of batch runs$1,15050$57,500
Total $552,500

Table 5B. ABC Stage-1 allocation (batch level allocation) for Product B: Activity pools, cost drivers, cost per cost driver unit, and total cost for these activities.

When each product's activity pool cost totals are known, the analysts can then calculate the cost per product unit, as Table 5C shows. To find product unit costs, the analyst divides the activity pool cost totals by the number of product units. In ABC, the process of finding product unit costs isstage-2 allocation, or product level allocation.

Stage 2 allocation in ABC: Allocating activity pools to product units

     Activity Pool

Total Indirect Cost
Product A
[From Table 5A]
Cost per product unit
Product A
Total Indirect cost Product B
[From Table 5B]
Cost per product unit
Product A
Total indirect cost
A+B
17. Purchase orders$135,000$0.15$45,000$0.02$180,000
18. Machine set ups$225,000$0.25$150,000$0.07$150,000
19. Product packaging$180,000$0.20$100,000$0.05$280,000
20. Machine testing
& calibration
$100,000$0.11$200,000$0.09$300,000
21. Maintenance  
& cleaning
$230,000$0.26$57,500$0.03$57,500
Total  $870,000$0.97$552,500$0.26$1,422,500
Table5C. Stage-2 allocation in ABC: Allocating activity pool costs to individual product units. The cost per product unit figures for product A and product B (second and fourth columns) derive d from the cost sums for each activity pool (first and third columns) divided by the number of product units produced and sold for each product (Table 2, line 1).

The total product unit costs for each product correspond to the total indirect costs for each product from the traditional costing approach.

Finding Overhead Costs Per Unit in ABC

Table 6 below shows how these costs contribute to the new version of profitability calculations for each product.

     Products Compared

Product AProduct BTotal
22. Units produced and 
sold  [Table 2, line 1]
900,0002,100,0003,000,000
23. Total direct costs
[Table 2, line 8]
$1,125,000$2,100,000$3,225,000
24. Total overhead costs
[Table 5C, line 21 ]
$870,000$552,500$1,422,500
25. Revenues per unit
[ Table 2, line 2 ]
$3.00$2.00 
26. Direct costs / unit
[ = 23 / 22 ]
$1.25$1.00
27. Overhead costs / unit
[ = 24 / 22 ]
$0.97$0.26
28. Gross profit / unit
[ = 25 −26 − 27 ]
$0.78$0.26
29. Gross profit margin
[ = 28 / 25 ]
26.1%36.8%
Table 6. Gross profit and gross margin calculation for each product, using activity based costing for indirect, or overhead costs.

Conclusions: Activity Based Costing Example.

  • Estimated Indirect (overhead) cost per unit is quite different for each product, unlike the traditional costing example above where indirect costs per unit were the same for both products. This approach recognizes that product A uses more activity pool resources than product B.
  • On a per unit basis, ABC finds product B more profitable than product A. The gross margin rate of 36.8% for B compares with a gross margin of 26.1% for A.

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Comparing ABC and Traditional Costing
Advantages and Disadvantages to Each Approach

Costing Results from Two Approaches

Table 7 below shows the per-unit profitability estimates for each product from the examples above.

     Product Profitability (Gross Profit Margin)

Product AProduct B
Traditional cost allocation
(Production volume based allocation)
42.5%26.3%
Activity based costing approach26.1%36.8%
Table7. Comparison of profitability estimates from two different costing methods. Traditional costing shows product A more profitable than product B. ABC based costing shows the reverse. These differences result from the different treatment of overhead costs.

Key Differences Between Costing Methods

The tables and examples above illustrate some key differences between the costing methods:

Data and Analysis

  • Activity based costing requires detailed knowledge of the activities and resources that go into overhead (or "indirect") support work.  
  •  Traditional cost accounting (production volume based allocation) requires only a total overhead cost and a simple allocation rule.

Overhead Components and Products: Differentiation vs. Aggregation

  • ABC recognizes that individual overhead components can be distributed differently for different products. One product may consume relatively more maintenance resources, for instance, while another product may consume relatively less maintenance resources but relatively more machine set up resources.
  • Traditional cost accounting typically puts overhead components into fewer categories, or even a single category, and uses a single allocation rate for all products. 

Direct vs. indirect measurement

  • Activity based costing treats overhead costs essentially as direct costs, in that cost estimates reflect actual cost driver usage for each product. These costs, in turn can be reasonably be apportioned to individual product units.
  • In traditional cost accounting (production volume based allocation), the total overhead cost is known accurately. However, in traditional costing the distribution of that total to individual products is based on an indirect measure of that cost.

Costing Accuracy vs. the Cost of Costing

For the profitability figures shown in Table 7 above, the activity based costing results may be taken as the more accurate results—more closely reflecting the "true" production costs of products A and B—than the profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies the higher cost of applying this costing method, however, is a question management will have to investigate and answer before committing to a comprehensive new approach to costing.

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Explaining Activity Based Management ABM
What is the Role of ABC in ABM?

Note especially that the purpose of ABC is to provide management with information for decision support and planning. Organizations that use ABC consistently, to pursue costing accuracy, are practicing activity based management ABM.

Adoption of ABC and ABM

ABC first appeared in the mid 1980s. Since that time, the percentage of companies and other organizations using the approach has increased more or less continuously. However, as mentioned, nearly four decades after it first appeared, the majority of companies and organizations still do not use activity based costing, and do not practice activity based management. 

Implementing Activity Based Management ABM

Regarding implementation, activity based costing requires detailed and complete information on specific activities that go into specific products, services, and tasks, as well as detailed and complete information on the resources consumed by these activities(including time, labor, and other goods and services). Implementation in large, complex organizations is therefore a labor-intensive and data-intensive undertaking. 

Since the mid 1980s, however, ABC has  become more accessible and more affordable to many companies through two ongoing trends.

  • Firstly, recent improvements in costing software.
  • Secondly, the increasing availability of data from complex, comprehensive software systems, such as enterprise resource planning (ERP) systems, manufacturing resource planning (MRP) systems, and customer relationship management (CRM) systems.

ABM Started in Manufacturing

When first introduced, the obvious benefits of ABC were most readily seen in product manufacturing settings, as the two numerical examples above show. From the start, it was clear that in such settings, the ABC is superior to traditional cost accounting for the purposes of:

  • Identifying truly profitable and truly unprofitable products.
  • Finding and eliminating unnecessary costs.
  • Identifying and distinguishing between true value-add activities and non-value add activities.
  • Pricing products so as to achieve acceptable margins.

Activity based management: Moving beyond manufacturing

Increasingly, however, the value of more accurate costing has become more widely appreciated, leading to the application of this methodology for the purposes of:

  • Budgeting and financial planning.
    Organizations can anticipate overhead costs and funding needs with greater accuracy and more certainty under ABC.
  • Human capital management.
    Firms can now direct human resources into more profitable activities under ABC.
  • Performance measurement.
    Managers can evaluate the performance of individuals, groups, projects, initiatives, and programs, with more certainty and accuracy when their true costs are better understood through ABC.

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By Marty Schmidt

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