A different approach to activity-based costing (ABC)

June 27, 2015

Activity-based costing has been around for some time and is used by some of the largest and successful companies in the world.†This costing approach, though, may require a lot of internal resources to develop and maintain.†In this article, we will discuss a new flavor of this costing method called time-driven activity-based costing.

1. Traditional (basic) activity-based costing

Activity-based costing has been around for some time and is used by some of the largest and successful companies in the world. This costing approach, though, may require a lot of internal resources to develop and maintain. In this article, we will discuss a new flavor of this costing method called time-driven activity-based costing.

1) Traditional (basic) activity-based costing

Activity-based costing (ABC) in its traditional form calls for the following procedures:

  • Determine the costs associated with activities.
  • Perform interviews, observations, or logs review to figure out the amount or percentage of time employees spend on such activities.
  • Calculate activity cost driver rates.
  • Assign costs to individual products or customers by dividing these activity costs by the outputs of each activity.

Traditional ABC System Example

Letís look at a simple example with just two activities. Assume that an accounts receivable clerk performs these major activities: (a) prepare customer invoices and mail them out, and (b) apply posted cash to open invoices. Costs associated with these activities include the clerkís compensation and benefits, equipment (computer and printer), and supplies (paper for printing, etc.) and total $100,000 per year.

As the first step, the ABC system designer asks the accounts receivable clerk how much time is spent on the two activities. In our example, the clerk indicates that 70% of time is devoted to preparing and mailing invoices and 30% is spent on applying posted cash to invoices. The ABC system designer also determines that the accounts receivable clerk prepares and mails out 14,000 invoices and makes 10,000 cash applications per year. Using this information, the ABC system designer calculates the activity cost driver rates:

Activity

%

Assigned
Cost

Activity
Quantity

Activity Cost
Driver Rate

Prepare/mail invoices

70%

$70,000

14,000

$5.0/invoice

Apply posted cash

30%

$30,000

10,000

$3.0/cash application

Total

100%

$100,000

   

The activity cost driver rates can then be used to assign costs to individual customers. For example, the accounts receivable clerk prepared 50 invoices and made 20 cash applications for Customer ABC during January. These activities would be assigned a cost of $5.0 x 50 + $3.0 x 20 = $310 and would be associated with Customer ABC for invoice processing and cash application in January.

Issues with Traditional ABC System

The traditional ABC system has its drawbacks. In particular, it takes a significant amount of resources to introduce an ABC system because it requires lots of interviews, logs review, analysis, etc. There is software that can be utilized, but this process is still resource intensive. Next, the cost driver rates may not be accurate because they are based on what employees believe they do and sometimes the reality is different. For example, the accounts receivable clerk thinks 70% of time is spent on preparing and sending invoices and 30% of time is devoted to applying posted cash. The reality may be 50% and 50%, respectively. In addition, the traditional ABC system does not take into account any downtime (nonproductive time), so the full cost pool is allocated to assumingly productive activities. Finally, it is hard to maintain and scale a traditional ABC system. Specifically, any time there is a change in processes or costs, the activity cost driver rates need to be updated. On top of that, if a particular process has variations (e.g., prepare a domestic invoice which takes 10 minutes and prepare an international invoice which takes 30 minutes), the activity cost driver rate will be the average of the two and may not accurately assign costs to individual customers (or products); in this case, the process may need to be reviewed separately for each variation requiring more calculations, time, etc.

There is an alternative to the traditional ABC system called time-driven ABC which can help minimize or eliminate the drawbacks of the traditional system. Robert Kaplan and Steven Anderson describe the time-driven ABC system in their article called Time-Driven Activity-Based Costing. Letís take a look at what this alternative system represents.

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