When using accounting standards to evaluate fixed costs, there are a number of approaches one can take. Each one will tell a different story about these overhead costs and how they will contribute to a final price point. While assumptions can be made to roughly divide fixed costs out over units produced or machine hours, there are other methods that can be used to divide costs out in a way that tells the business a little bit more about the way internal costs all play out.
Manufacturing industries tend to use activity-based costing since overhead costs are a large portion of overall production cost.
Activity-based costing (ABC) is an accounting method used to assign overhead and indirect costs to the production of goods and services. With activity-based costing, the business identifies activities within the company and allocates the costs of these activities to each product and service proportionally, based on an estimate of usage. This allows the company to better understand and track the costs of the activities required for production, since each activity is defined as a cost and then divided between products as needed.
For example: a plant is trying to compare the production costs of two products, A and B, both of which take six hours of production time. Using a standard allocation, which just evenly divides overhead costs over units, these products would appear to have the same cost of production. However, if product A takes six hours on a normal machine and product B takes six hours on a more complex, expensive machine, the production cost of B is actually higher than A. In this example, use of each machine counts as an activity, and thus activity-based costing reveals expense that needs to be captured within product B that doesn’t appear in product A.
The first step in making an activity-based cost calculation is to define the activities that go into the production of the company’s goods and services. This process can devolve into micro-transactions, so when initially dividing the production process up into activities, be sure to set some boundaries. The best way to effectively capture the activities needed to define ABC calculations is to talk to the employees in the plant, out on the floor or on the front lines of customer service. They will understand the differences in processes that need to be captured when different types of products are made.
Keep in mind that activities aren’t always individual actions, as well. Utilities can be defined as an activity, assuming different machines may require different amounts of electricity or gas to run, for example. Even salaries can be allocated using activity-based costing; for example, an operations crew may spend 15% of their time making product A but only 5% making product B, or maybe a product development representative must be present to make type C but not type D. Making these kinds of definitions can be extremely helpful when tracking internal costs. Any activity that could cause costs to increase should be defined within the ABC framework.
Activities may not even be directly related to production. Consider the resources spent to take orders, change production schedules, purchase raw materials, manage warehousing and storage and make sales; if these activities result in varying costs to the company, they may also need to be included in an ABC evaluation to really get an accurate understanding.
The second step is allocation: assigning each product type a proportion of each activity. Again, this process carries the risk of becoming too complicated to be meaningful, but overall it should be fairly easy to estimate.
For example, a plant with four production lines might capture the percentage of time each product takes on a particular line, and how often products are run on these four production lines. Likewise, electricity would be allotted to each type per the plant’s usage of the utility. For every activity defined, it’s important to determine what portion of that activity goes into each type of product.
The third step is to obtain the cost of each activity and then calculate product costs accordingly. Some activities are easy to estimate cost for, such as utilities or salaries; others, like the cost of machine use, will require the knowledge of technical staff as well as accounting to assign costs to. Once costs have been assigned to each product type, a report of sorts is generated highlighting the significant contributors to production cost across the company’s entire product portfolio.
Like all accounting methods, there are advantages and disadvantages to activity-based costing. As a general statement, the advantages include the additional information this activity-based breakdown can provide, while the disadvantages involve the level of detail involved in making these calculations.
The advantages include:
- Increased accuracy in product and service pricing, leading to more realistic pricing decisions, which can increase revenue.
- More specific information about cost drivers, allowing a better understanding of overall production costs.
- Identification of high-cost, low-value activities that can be cut or eliminated to improve production efficiency.
- Potential improvement of manufacturing and business processes to reduce waste and decrease allocated costs.
- Reevaluation of the product portfolio based on truer costs of products and profit margins.
- Complexity of implementation, which can add cost of its own, in time and money.
- Complexity of analysis, which requires accounting experts as well as manufacturing representatives to be done properly.
- The resulting data is only as good as the assumptions that went into the division and cost estimation of the activities being tracked.
- Difficulty in assigning certain overhead costs, like executive salaries or administrative costs, to various types of product.
- Reports using activity-based costing may not meet generally accepted accounting principles, which means additional reports will need to be run for regulatory purposes.
- Management and executives used to traditional costing may not immediately understand or accept ABC calculations .
Activity-based costing is the most helpful in manufacturing industries, where overhead costs are a very large portion of production cost. If you were to look at a list of companies using activity-based costing, you might be surprised to see it filled with familiar names. The introduction of automation and digitally-controlled technologies can reduce direct costs like labor while increasing indirect costs like machine and program maintenance and upkeep, which would register as overhead.
Activity-based costing is especially important in industries that produce custom materials; custom materials often require more expensive raw materials, which is captured in the variable costs, but can also require different or advanced production equipment to handle said raw materials, which may not be entirely captured in the price of that raw material upfront. As automation and the reach of control systems continues to move into the manufacturing industry, the indirect costs of maintenance, upkeep and utilities become more important when trying to differentiate product costs.
Activity-based costing can also be incredibly useful for small businesses just starting out and trying to capture an understanding of cost. Small businesses can often have trouble capturing overhead costs during their initial growth and establishment phase. Using activity-based costing forces the business to spend time defining the activities that can increase cost, which leads to a better understanding of expenses and more accurate product pricing. Also, with a small business, the complexity of the process decreases drastically, since often there are only a few cost-increasing activities that need consideration. In many cases, the advantages of ABC can outweigh the disadvantages.
Many automotive companies use activity-based costing to determine their costs and pricing. For example, Ford decided the company needed this sort of determined, specific look into individual cost steps to see which steps could be eliminated or improved.
Chrysler has seen hundreds of millions of dollars saved using activity-based costing to identify and eliminate useless, inefficient or redundant steps in its production, which has also significantly streamlined product development. Since car and truck manufacturing is an established industry, where the manufacturing process has many steps that combine to make the final product, activity-based costing is the ideal analysis as long as the company has the resources to implement it and follow through on the points it highlights.
Coca-Cola is another company that uses activity-based costing to determine its price points. Coca-Cola offers a large portfolio of products and carries a huge amount of inventory, which can be a significant portion of production cost that is often overlooked. Coca-Cola has used activity-based costing to evaluate the differences between its bigger, world-wide products and its specialty, regionalized products that it may not offer on the global market. This understanding of how production costs are different between established, familiar types and specialized types has enabled them to set price points in each market that ensure them significant profit.
The concept behind activity-based costing can actually be implemented throughout a business to shape the company culture. This requires significant buy-in at every level, but can help a company better focus its resources and efforts, as well as identify portions of the day-to-day process that cost too much in time and resources and need to be improved.
Activity-based management follows similar principles, in that it looks at all of the steps of a business process and determines relative costs for each, in order to highlight areas where efficiency improvements can have a significant impact.
The key to using activity-based costing as a philosophy outside of operational realms is focusing on which steps in any business process add value as compared to their cost. For example, a purchasing department has a set of steps: receiving the purchase requisition, obtaining approval, making the purchase order and ordering the material in question, sending payment, receiving the object and recording the receipt.
Activity-based costing philosophy would create a cost for each step, based on the salaries of employees involved and the time each step takes to be completed, and then would look at the costs of each step to determine where value is being wasted. For example, while approval of a purchase requisition may only take each manager a few seconds, if the entire approval process takes two weeks, that’s a significant amount of cost to the company in time wasted waiting for the order to be made. Or, as an alternate example, if the receiving process has to be done manually while everything else is automated, it might make sense for the company to look into the cost of automating that step as well, if ABC calculations show it as a significant expense.
Overall, activity-based costing allows a company to better break down the elements of their business process that actually add cost, be it operational costs like machinery and manufacturing, or more administrative costs like interpersonal processes or company policies. The success of the process, however, depends on how the company evaluates and uses the data that comes out of this type of accounting calculation.
A company that isn’t willing to significantly invest in the portions of its process that cost time and money to make significant improvements will find little value in activity-based costing. A company that’s willing to strategically apply its resources to improve its most expensive process steps, however, will find a huge benefit in ABC.