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Asset Management for Human Capital

Activity Based Costing is a cost accounting system that assigns costs to products or services based on the resources they consume and can be used to track these costs to customers. ABC is used for many reasons:

  • determining a competitive price
  • developing budgets
  • measuring performance
  • evaluating outsourcing options and
  • estimating future costs.

ABC involves dividing a cost object into specific activities and then selecting an Activity Driver for each activity. We use Cost Drivers to find out costs of cost objects. ABC goes a step further by evaluating the cost of each activity involved in producing a cost object.

The problem with other cost accounting methods is that different products consume different amounts of fixed costs and overhead. If these differences are not accounted for in the costs of the product then the company may be losing money on a product without knowing it.

Through the ABC process, cost savings may be identified, and the activity may be restructured (or eliminated). The purpose is to identify which activities add value to the cost object and minimize those that do not.

There are also resources employed to perform activities that do not produce end products or services and but still support customers or markets. These are classified as business sustaining activities, and in ABC they must be proportionately allocated to products. Indirect cost tracking is vitally important so that that items such as regulatory reporting, business development, and idle capacity are included in evaluating the firm's competitive position. [This concept is accurate in the American marketplace, check with your local accounting professional to ensure this is accurate in your country.] 

Steps to ABC

  1. Cost Object
  2. The first step to ABC is determining the cost object. This involves identifying the subject(s) for which you want to know the costs. In ABC this is any product, service or material that goes into your final output sold to consumers. These are direct cost objects. Additionally, we specify in American accounting, that indirect costs are allocated as a percent of total sales (Sales/Quantity Sold gives = indirect cost %).

  3. Identifying activities
  4. The second step to Activity Based Costing is identifying and defining activities that are involved in producing the cost object. A group meeting using DACUM[1] is a good way to do this. In your meeting, write each cost object down on a separate piece of paper. In a department meeting, begin with the outputs of your department. In a company setting, start with the final products of the company. Next, list activities under each cost object that are involved in producing it. This may involve lengthy discussion of group activities. It is important to thoroughly examine the cost object to get a good list of activities. But, remember, a usable list is the goal, so you do not want it to be too long.

    Therefore, you may need to group certain activities together. At this stage during your discussions you should analyze the activities to determine whether they are adding value to the department or company.

    Be aware that when activities are defined at too detailed a level,
    you identify thousands of activities. It is difficult to manage this much data especially when a company is just starting activity based costing. Another obstacle can be defining activities at too high a level (the view one might get flying in a plane over a field) such that you identify only 20 to 25 key activities for a complex cost object. Understanding the mental model of data layers, to help shift between viewpoints helps in this regard.

    Activities that perform similar functions (e.g., front offices of multiple branches) can be reviewed in groups to make sure nothing is overlooked. Typically the most complex example of the group is discussed in detail, and then the other similar entities within the group are reviewed to see if they have any different activities that need to be added to the list.

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