Activity-Based Costing: Principles and Implementation

Posted on Apr 3, 2025 in Modern Languages and Management

UNIT 5: The Activity-Based Costing System

Evolution of the Manufacturing Environment

Activity-Based Costing (ABC) emerged in the 1980s as a method to improve the assignment of costs to products due to several significant changes in the manufacturing environment:

  1. The automation of productive processes reduced the relevance of direct labor costs within total production costs.
  2. There was an increase in the importance of support functions.
  3. Companies began manufacturing a greater variety of products for diverse markets.
  4. The introduction of methodologies like Just-In-Time (JIT) and Lean Manufacturing changed production flows.
  5. Increased competition made accurate pricing decisions critical for company survival.

Limitations of Traditional Cost Center Models

Traditional two-stage allocation models, often based on centers of analysis, have limitations regarding the accuracy of cost assignment to products and the relevance of the information they provide.

Departmental Cost Control and Accounting Models

Centers of analysis can be used either to allocate indirect costs to production departments (improving product costing accuracy) or to allocate production costs to control departmental expenses.

Horngren suggested that management accounting extends beyond mere ledger entries. Using accounting reports separate from the ledger offers more advantages for departmental cost control than relying solely on ledger-based control accounts.

Consequently, two primary methods exist for accounting entries related to direct costs:

  • a) Direct Materials Consumption:
    • Theoretical Approach: Focuses on controlling departmental costs for accountability (inventory control) and controlling work-in-progress (departmental cost accountability).
    • Practical Approach: Primarily focuses on controlling work-in-progress (inventory control).
  • b) Direct Labor Applied: Similar accounting entries are made as with direct materials, but the focus shifts from controlling inventories to controlling staff costs associated with work-in-progress and departmental accountability.

Centers of Analysis and Cost Control

The delegation of responsibility necessitates the authority to manage required resources and an accounting control system for those responsible. Dearden proposed the following classification of responsibility centers for financial control:

  • a) Cost Centers: The manager is responsible for the resources consumed (costs). Financial control is achieved using cost accounting techniques like cost allocation to sections, products, and standard costing.
  • b) Profit Centers: The manager is responsible for variables affecting both costs and revenues, meaning the center’s profit is under their control.
  • c) Investment Centers: The manager is responsible for the profit generated relative to the assets employed (return on investment).

Lack of Homogeneity in Section Cost Allocation

Traditional systems often define management accounting centers based on functions. This frequently results in a single center containing a variety of costs with different behaviors, hindering accurate allocation.

The center of analysis system attempts to mitigate this by dividing sections into several homogeneous cost pools, where costs share the same behavior, aiming for a better correlation between the activity unit and cost levels.

ABC systems fundamentally change the focus:

  • From cost centers to activities.
  • From activities to cost drivers.

An activity is defined as a group of operations or tasks necessary to produce outputs. An effective activity should have measurable units of output and performance indicators. The concept of a center of analysis as merely a cost pool is replaced by the concept of an activity, which may require the participation of several sections or departments to be completed.

A cost driver measures the output of an activity and serves as the basis for cost assignment. It allows the allocation of an activity’s cost to a cost object (like a product or service) based on the consumption of the driver. Causality should be the primary criterion for selecting a cost driver, ensuring that costs are traceable to their origins.