Performance Operations: Grahame Steven Traces the Development of Activity-Based Costing and Shows How It Can Be Applied to Inform Activity-Based Management

By Steven, Grahame | Financial Management (UK), January-February 2010 | Go to article overview

Performance Operations: Grahame Steven Traces the Development of Activity-Based Costing and Shows How It Can Be Applied to Inform Activity-Based Management


Steven, Grahame, Financial Management (UK)


Many accounting experts in the eighties and nineties argued that absorption costing, which had been developed at the turn of the 20th century, needed to be replaced by new costing systems that were more appropriate for modern business. The main changes that had necessitated a different approach included the growth in production overheads relative to direct costs; the increase in factories' complexity (ie, they were making a far wider range of goods); the rising level of non-production overheads; and the growth of the service sector.

The key breakthrough in the development of what would become known as activity-based costing (ABC) was the realisation that many production overheads should not be charged to products on a single volume basis--eg, units made--because they weren't driven by these bases. Other factors gave a better explanation of why such costs were incurred. So a more effective way of charging overheads to products was achieved by creating cost pools for each of the main activities and then charging the cost of each pool to products using the cost driver--eg, the inspection of goods--identified for each pool. Activities were often classified under four categories to enable the identification of appropriate drivers: unit level, batch level, product level and facility level.

While it's acknowledged as a big step into modernity, ABC (like many good ideas) has its foundations in the past. The initial focus during the development of standard costing in the late 19th century was on direct costs, but even then it was recognised that overheads needed to be accounted for to determine the profitability of products. Alexander Hamilton Church was the first writer to make this point when he realised that product costs had to include prime costs (wages and materials), indirect shop costs (production) and general and selling expenses. He observed that the production and non-production overhead often "equals and sometimes surpasses in value the item of wages" in some companies. Contrary to the views of some modern writers, then, it seems I that some factories at the turn of the 20th century were already complex organisations with high levels of overheads. Church also criticised the use of time and percentages to charge overheads to products, since few i overheads related to these factors.

While he acknowledged that simple absorption methods wouldn't produce "alarmingly incorrect" costs in a factory with "machines all of a size and kind performing practically identical operations", Church noted that such an approach would not be "trustworthy" in complex factories producing diverse goods. He believed that product costing systems had to identify "the connection of expenditure of all classes with the items of output on which they are incident" to determine the resources required for each product--which sounds a bit like ABC.

1a Connoisseur Collection's P&L account

                                           Public  Corporate

Number of cases sold                       15,000      9,000

Sales ([pounds sterling])               1,050,000    567,000

Cost of sales ([pounds sterling])         576,000    334,800

Gross profit ([pounds sterling])          474,000    232,200

Operating expenses ([pounds sterling])

  Delivery

  Visits to customers

  Warehouse

  Web site

  Other selling expenses

  Finance and admin

Net profit ([pounds sterling])

                                           Retail      Total

Number of cases sold                       36,000     60,000

Sales ([pounds sterling])               2,052,000  3,669,000

Cost of sales ([pounds sterling])       1,296,000  2,206,800

Gross profit ([pounds sterling])          756,000  1,462,200

Operating expenses ([pounds sterling])

  Delivery                                           254,000

  Visits to customers                                 96,000

  Warehouse                                          192,000

  Web site                                            80,000

  Other selling expenses                             120,000

  Finance and admin                                  285,000

  Net profit ([pounds sterling])                     435,200

1b Current product profitability analysis of Connisseur Collection's
three markets

                                     Public  Corporate  Retail

Sales price ([pounds sterling])       70. … 

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