Activity Based Costing is an Accounting concept that has become more popular in recent years. Today, Managers are frequently choosing to use the ABC method, among others, in order to ensure an efficient allocation of resources. Activity Based Costing can be described as “a costing system that identifies the various activities performed in a firm and uses multiple cost drivers (non-volume, as well as the volume-based drivers) to assign overhead costs (or indirect costs) to products. ABC recognizes the causal relationship of cost drivers with activities.
” When predicting future costs, a major factor to consider is past cost behavior. Using Activity Based Costing to determine the cost of servicing customers is a process that includes a number of steps. These steps include: analyzing the data, determining the data, and using the data to make responsible managerial decisions. Although the ABC concept has been accepted by several Managers today, it has not been accepted by all. Managers possess both positive and negative outlooks on the Activity Based Costing method.
Some feel as though this method is a great advantage to their success, while others disagree. I will introduce you to some examples from both points of view. The authors, M. Krupnicki and T. Tyson, of the article, Using ABC to Determine the Cost of Servicing, used a small welding supply distribution company with seven employees and a diverse group of customers to show how ABC can be useful. The end result of this process, they say, “is better profitability analysis and the identification of cost reduction opportunities. ”
An ABC study was directed on the small family-run welding supply business. The purpose of the study was to determine the cost of servicing customers, and to identify appropriate cost reduction opportunities. Applying ABC principles to historical financial data was used to address the concerns that the small business owner had, so that he could actually see the problems and assess ideas on how he could correct them. The ABC analysis indicated that 15 different activities, ranging from billing to advertising caused costs to occur in the company.
After classifying the activities, performing time studies, finding a causal link between activities and costs, computing allocation rates, and putting data into a contribution margin format, the desired cost numbers were realized. Even if this analysis were not refined, and tried again, it still identified the costs of servicing different customers, which is the main reason that the project was conducted. The ABC study provided information that will help the Managers to make better decisions in the future.
While this data was very beneficial, and worth the while, the owner of the business stated that “The mechanics of an ABC system are forthright, but a company intending to conduct an ABC study must be prepared to spend sufficient resources to do so. People involved in the project must spend a great deal of time looking at what really drives costs in their business by observing activities, interviewing employees, and performing quantitative methods such as regression analysis.
A company that doesn’t allocate the necessary resources is destined to be displeased with the results. ” While there are many instances of Managerial satisfaction based on the outcome of the ABC analysis, there are also some instances of disappointment. An article written by Tony Rizzo, entitled: The Fundamentally Flawed Thinking Behind Activity Based Costing, demonstrates a negative outlook on the concept of ABC. The writer feels that every company that is managed according to the philosophy of Activity Based Costing, can never achieve performance levels beyond mediocre.
Managers that oppose Activity Based Costing, claim that the method causes many of us to think only in the terms of improving the cost of the activity, often by simply cutting the capacity of a department. They believe that it misleads us into thinking that we’re making “real contributions” to the company’s bottom line, by cutting functions and jobs that appear to be unneeded. They go on to explain that as a result, “many of us think not in the terms of looking for new markets into which we can sell the excess capacity, but in terms of eliminating the cost associated with the excess capacity.
We settle for saving pennies, when we might be able to earn millions. ” Some Managers also believe that Activity Based Costing blocks us from enjoying a steady sequence of growth spurt, by preventing us from ever enduring any excess capacity. Excess capacity is an absolutely necessary condition for business growth, if you don’t have the spare capacity to produce additional products, then you can’t possibly sell any products at all. In some cases, Managers find that the method of Activity Based Costing is beneficial to their success, while others prefer alternative standard costing methods as a replacement.
From my research, I have concluded that the decision to use the method of Activity Based Costing is based solely upon the Manager’s preference. Outlooks vary depending upon research, or negative outcomes that certain Managers might have experienced in past situations; these might all be influential factors when determining the best strategy for a particular firm to use. Sun Life Insurance is a Toronto based insurance company, providing individual corporate life insurance, group retirement services, and benefit management services.
The company’s “Claims Division” provides drug and dental claim management to companies across Canada. The company faced increased competition and customer demand. Its profit margin decreased due to increased costs and decreased revenue per unit. Under these circumstances, the company was left with no alternative, but to reduce cost, reduce the time taken to process claims, and increase the work performance of the employees working on claims. The company decided to hire a consultant to assist in implementing an ABC system.
This helped the company to conduct an activity analysis, create a consolidated activity dictionary and cost flow diagram, and also to collect resource and activity driver information. The ABC analysis revealed significant differences in activity costs, process costs, cycle time, transaction volumes, and unit costs; both within the same location and also across different locations. Remedial measures that were taken include introducing Managers to the analysis and its data, in order to ensure that they were comfortable with the results.
The ABC results have focused the Manager’s attention on the importance of measurement; and also management of those measures. Using ABC, Managers are now able to considerably reduce the absolute activity costs as well as the unit cost of the major claims processing activities. As a result, the ABC system helped Sun Life realize significant reductions in operational costs within the Claims Processing areas. Having the ability to compare data from different locations, allowed Managers to set up the best practices in every location, and achieve their desired results.
Sun Life Insurance demonstrates a real-life situation, in which a company was able to use Activity Based Costing to their advantage. The outcome was positive and beneficial to the growth, as well as the future success of Sun Life Insurance Company. The concept of Activity Based Costing is becoming more and more popular and Managers are beginning to further implement this method into their strategies of efficiently allocating their resources as time goes on. As some Managers would rather refrain from using ABC, others have found this concept to be very advantageous and effective, and will continue to utilize the method in years to come.