Implementing Activity-Based Costing

By Compton, Ted R. | The CPA Journal, March 1996 | Go to article overview

Implementing Activity-Based Costing


Compton, Ted R., The CPA Journal


The author has developed a primer on activity-based costing (ABC). He first presents the whys and wherefores of ABC. He then provides a comprehensive case analysis to illustrate the merits of ABC systems modeling and how computer technology can and should be used in making ABC work.

Businesses operate in an uncertain and competitive world; accurate cost information is a primary weapon for survival and success, whatever the industry. If a company can't maximize information gathering and utilization capacity, it will be left in the wake of those who can. Companies, successful in disseminating relevant information, i.e., providing information empowerment to all levels of their operations, can be on their way to becoming world class organizations. Many organizations have found the pursuit of this mission can best be achieved by installing activity-based costing (AB) systems.

Many companies are doomed to failure before they begin installing ABC systems, in part due to a number of misconceptions about ABC systems and what they are actually designed to accomplish. Another major reason for failure is a faulty planning, design, and implementation strategy. The purpose here is to provide a road map that will increase the likelihood of success.

Some Misconceptions

Some proponents of ABC suggest that the cost of a product can be computed by calculating the activity based cost for each component and subassembly. Care must be taken with this approach to product costing, sometimes called roll-up costing. If the activity-based cost of a part is developed from cost roll-ups, each product using that part will bear an equal share of the overhead costs associated with the part. But one of the products may be responsible for a greater share of the overhead costs associated with the part because the product in question has a less stable production schedule and is the cause of most of the expediting costs associated with the part. This is further illustrated in the accompanying Case Study.

Another misconception is that ABC systems cannot calculate product costs accurately because of the difficulty in tracing activity costs to products if activities are not performed on the products. While cost allocation procedures are by nature arbitrary, well designed ABC systems use cause-and-effect criteria for defining how costs are to be allocated. For example, most purchasing activities are oriented toward the acquisition of components. Because components may be common to many products, it is difficult to come up with activity drivers that precisely trace the cost of purchasing activities to specific products. In such cases, activity analysis will yield an activity to trace costs to products more accurately than conventional cost systems.

Still another misconception about ABC is that it replaces the existing cost system. One essential function of conventional costs systems is to value inventory used to generate financial reports in accordance with FASB, IRS, and SEC requirements.

Although there is no prohibition against a company utilizing ABC analysis to value inventory, most companies use ABC systems for internal reports designed to help manage costs and improve performance. ABC systems are intended to complementnot replaceconventional cost accounting systems.

Probably the greatest misconception about ABC is that it does not work well for service organizations. ABC is equally valuable as a management tool in service organizations as it is in manufacturing finns. The same methodology and cost- flow concepts can be utilized in developing activity-based modeling for either type of organization. All that differs are the particulars, e.g., patient visits instead of machine hours or activity costs instead of manufacturing conversion costs.

Selling ABC to Management

To be successful, an organization must be committed to ABC. The effective use of ABC information technology must start with the endo and support of top management and user groups. …

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