Logistics Activity-Based Costing

Activity-based costing is defined as:

“[a] methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities, then activities are assigned to cost objects based on their use. Activity-based costing recognizes the causal relationships of cost drivers to activities.”²

ABC assumes that activities cause cost and that cost objects create the demand for activities. The assumption enables ABC to determine product costs by summing the costs of activities required to manufacture or deliver a product.

ABC assigns overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. ABC first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities (see Figure 20.1). ^{[1] [2]}

The advantages of activity-based costing are:

• Assigns costs to products according to the activities performed on them
• Tracks cost to activities and work process
• Reveals the links between performing particular activities and the demands those activities make on available resources
• Has activities as cost drivers (as against the traditional approaches that allocate direct and indirect costs on a proportionate basis using volume-based cost drivers). Volume-based cost drivers will distort costs whenever products consume resources in disproportionate amounts
• Identifies the profitable/non-profitable customer, product and channel
• Finds the root cause of poor financial performance for a firm

In ABC the first stage focuses on determining the costs of activities within an organization. The second stage traces activity costs to the products consuming the work performed. The two- stage assignment process enables ABC to overcome the problems encountered with using tradi­tional volume-based allocation techniques. This approach addresses the management and control of overhead costs within an organization. ABC increases management visibility about how products, customers, or supply channels consume resources. The assignment technique recognizes different cost relationships and uses multiple cost drivers to assign costs. The non-financial information produced by the ABC model facilitates the development of performance measures and continuous process improvement. However, the basics of the ABC system are:

• Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product
• Products do not consume costs directly
• Money is spent on activities
• Activities are consumed by product/services
• Assigns costs to products by tracing expenses to activities
• Assigns costs that reflect the physical dynamics of the business
• Provides ways of assigning the costs of indirect support resources to activities, business pro­cesses, customers and products
• Many resources are required not for the physical production of the product, but to provide a broad array of support activities

ABC can improve the management and control of overheads by determining the factors driv­ing the requirement for overhead resources. The ABC approach divides overhead into separate resources supporting the work performed in the organization. The resources could include cat­egories such as general administration, supervision, supplies, direct labour or utilities. Resource drivers trace costs to the activities consuming the resources. The costs may reflect actual consump­tion or may result from an estimate of the effort expended on each activity. The sum of the resource costs becomes the cost of performing an activity. ABC uses an activity driver to assign the activity costs to specific cost objects. Analysis of the activities and cost objects may identify free resources. ABC costing normally addresses the following questions:

• What activities the organizational resources are performing?
• How much does it cost to perform activities?
• Why does the organization need to perform those activities?
• How much of each activity is required for the organization’s products, services and cus­tomers?

An ABC analysis will allow managers to pinpoint the activities, products, services or customers consuming overhead resources. Managers can examine ways to reduce or eliminate resource con­sumption. Cost reduction methods can focus on improving activity efficiency by:

• Reducing the number of times the activity must be performed
• Eliminating unnecessary or redundant activities
• Selecting a less costly alternative, or using a single activity to accomplish multiple functions

Thus, the freed resources can be redeployed for additional output or eliminated to achieve cost saving.

Source: Sople V.V (2013), Logistics Management, Pearson Education India; Third edition.