Activity Based Costing

According to Weil and Maher, most accountants agree that activity based costing emerged in the mid 1980s. Between the 1950s and 1970s American companies' main focus was on output and not quality or cost control. This happened until the 1980s when Japanese companies started producing high quality goods at a lower cost. They did not have a highly developed costing system but they were simply producing a smaller number of higher quality products. In order to compete with these foreign markets and producers such as the Japanese, Americans needed to find a way to reduce costs and increase quality. (Weil, Maher 218)

David M. Katz explains in his article that Activity Based Costing Systems emerged in the late 1980s in the United States but it was first explained by Robert Kaplan and Willam Bruns, both Harvard Business School professors in a chapter of their 1987 book Accounting and management: A Field Study Perspective. Their idea was completely revolutionary. In broad terms, Activity Based Costing involves identifying the cost drivers and assigning them to the different activities of the production process, rather than attributing the overhead to the whole organization (Katz, 2002).

Although Robert Kaplan and Willam Bruns as well as their partners brought light on to the subject of Activity Based Costing and explained in detail its benefits, they were not the first ones to come up with the idea. Management accounting historians consider Alexander Hamilton Church one of the most influential people of the 20th century. Church wrote an overhead in 1901 in an article, which was published in the Engineering Magazine. He developed a shop analogy "in which each production center was treated as a separate factory, to illustrate how the firm should charge each production center for each of the many types of manufacturing overhead." (Weil, Maher 737). He later then, in 1909, published a six-article series in the Engineering Magazine, which later in 1910 became a book: Production Factors in Cost Accounting. Church's work presaged the modern concept of activity-based costing. (Weil, Maher 737).

While a traditional absorption costing system may be cheaper to operate, sometimes they can be highly inaccurate, resulting in far greater losses. Activity Based Costing is more accurate, effective and is becoming cheaper and cheaper to operate due to the falling price and the rapid evolution of Information Systems.

Robin Cooper and Robert S. Kaplan state in their book The Design of Cost Management Systems that traditional costing systems:

"assign indirect and support costs to products with volume-based cost drivers, such as direct labor, machine hours, and material dollars. This practice leads to distortions in the calculation of product costs because many indirect and support costs are not used by products in proportion to their production volumes. " (Cooper, Kaplan, 208)

When discussing activity based costing one should remember the fallowing:

- Activity Based costing provides a more detailed and accurate measure than traditional costing systems.

- By providing more accurate cost numbers this can help marketing people select and price products more efficiently.

- It provides more information on how much each activity undertaken in the production process costs, thus it helps managers identity the cost drivers (that they could not previously recognize).

- ABC provides more information about product costs but it requires more record keeping. Also there are added costs of the measuring and obtaining of this data. Managers must take this into consideration and decide whether the added costs and effort of implementing an ABC system is justified by a reduction in costs.

- The implementation of an ABC system require a joint operation between the accounting, production, management and other departments

(Weil, Maher, 2005, 222)

When designing and implementing an Activity Based System for an organization one should take the following steps:

1. Identifying the major activities performed within an organization

"Activities are composed of the aggregation of units of work or tasks and are described by verbs associated with tasks." (Drury, 2006, p. 360)

In order to identify the activities performed within an organization or a firm an activity analysis is needed. Innes and Mitchell suggest that this is done by carrying out a physical analysis of the workplace and identify how all workspaces are being used. Also an analysis of the payroll is necessary to make sure that all personnel and staff have been taken into account. Additional interviews with staff members will start to reveal the main activities that are being performed. In early ABC systems hundreds of separate activity cost centers were being identified but recent studies suggest that it should normally be in between twenty and thirty. (Drury, 2006, p. 360 - 361)

2. Assigning costs to activity cost centers.

Following the identification of activities performed within an organization we must then identify and assign the cost of resources consumed by each of these activities over a specific period of time. Most resources will be directly attributed to specific activity centers but others such as heat and lightning maybe indirect and will be shared between several activities.

Interviews with staff may help you identify reasonable estimates on the resources consumed by each activity.

"The greater the amount of costs traced to activity centers by cost apportionments at this stage the more

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