Activity based costing is a financial reporting system that provides managerial information. It communicates the rate at which activities consume resources as well as why the resources are used.
Some short definitions that describe activity based costing:
- a method that measures the cost and performance of process-related activities and cost objects.
- assigns cost activities based on their use of resources, and assigns cost to cost objects, such as products or customers, based on their use of activities
- recognizes the causal relationship of cost drivers to activities
- provides "total delivered cost" information
Activity based costing is an old concept that has continued to evolve as business environments have become increasingly complex. The escalation in complexity, variety and diversity in business has bred higher overhead costs and has made direct costing methods which measure hands-to-product labor and purchased material less effective management tools when assessing the true cost of a product.
The main reason for a company to employ activity based costing is to properly allocate overhead costs to product-costing which direct cost models do inadequately or not at all. Overhead and indirect costs are typically controlled by using responsibility cost center budgeting. However, responsibility cost center budgeting loses effectiveness as the internal supplier-customer chain is followed. For example, when a purchasing agent saves a dollar by buying a substandard product, other downstream departments will make up for it in rework, overtime, or quality. The cost of poor quality moves down the chain of command, leaving the seminal perpetrator blameless.
For an example of the destructive power of cost center accounting, we can turn to a stomach-churningly bad early 90's movie called Disclosure. In it, Michael Douglas is the hapless project manager designing a billion dollar virtual reality filing system written with enough technical fallacy to make Plan 9 From Outer Space look competent. Demi Moore, playing a role which arguably began her career freefall, is the manager cutting corners who plans to get Michael Douglas fired through a twisted melee of reverse sexual harassment which started out as main text and inexplicably became subtext by the middle of the movie as we find out that she has secretly been undermining his efforts to turn in a project on time and under budget. In the movie's climax we find out that she ordered substandard equipment and inefficient, cheap labor. No one would have realized that the fault began somewhere at the top under a system of cost center accounting because all the cost of poor quality and rework would have fallen squarely into Michael Douglas' project. However, in a classic deus ex machina, he happens to find film footage of his evil nemesis surveying the product line and applying ham-fisted management tactics.
The weakness of general ledger and cost center accounting is that it focuses on what is spent in each department. Activity based costing describes how it is spent. It takes the same numbers and reslices the pie in a way that reflects the resource cost of people, computers, technology, equipment, supplies, tooling and other factors. Before we had computers, such re-shuffling was nearly impossible and too time consuming to be cost effective. Hewlett-Packard was one of the first companies to create an activity based model. As the flexibility of the cost model became more apparent, it evolved into activity based management, a more encompassing plan, which includes the managing of costs as well as more proper assignment of costs to processes and products.
Business problems inherent in most manufacturers are process engineering, cost-of-quality improvement, cost driver performance, price quoting, make/buy decisions and cycle time reductions. Activity based costing addresses all of those concerns and a well-informed manager can use that data to make the best possible decisions.
And lo, my skills could save Michael Douglas' punk ass.