The Activity Based Costing System Or ABC System

Before talking about the Activity-Based Costing system, also known as the ABC system or ABC cost model, and other important cost systems in business management, let’s look at the reality we find ourselves in…

“I hope you live in interesting times,” says a famous Chinese curse that seems to have fallen on us with all its power. And it is that the quantity and depth of the changes that affect our lives are such that we are still unable to guess the effect they will have on society.

In the business field, the immediate consequence is that the Management faces serious problems due to increased uncertainty, which multiplies the risks inherent in decision-making.

We are experiencing a growth of variability in events external to the company itself, added to that of normal internal origin in the development of business and corporate growth. And it is that the evolution of the environment has specific characteristics that had never occurred before with the current intensity:

• Increasingly global markets, which increase business opportunities and the degree of competitiveness. At this time, the risk does not lie in not doing things well but in that your competitors do it better than you.
• Great speed in changes, which requires immediate actions to be able to adapt.
• The use of technology and digitization as disruptive factors in the business world.

Understanding risk as the probability that the actions undertaken will generate significant losses for business activity, we see that what is really at stake is their very survival. And that this will be given by the ability to adapt and change within a strategy set by the Management to achieve the proposed objectives.

In this situation, knowing one’s business reality is an important advantage. Knowledge to which must be added accurate and timely information regarding the impact that the development of events could have on the economic-financial situation of the company.

With these data, one is more aware of the Margin available in decision-making and the immediate result thereof. And this makes it possible to reduce the time necessary to adopt the appropriate corrective measures that make it possible to reverse a potentially dangerous situation for one’s interests.

The cost system in business management

Cost accounting aims to provide the clearest possible information to those responsible for Management. Thanks to it, the functions of planning and controlling the company’s internal activity are facilitated, in addition to being able to assess the inventories and work carried out by it.

Due to the nature of the information, it deals with; analytical accounting greatly impacts the company’s key decision-making. For example, the pricing policy, the advisability of stopping manufacturing a product or increasing the production of another, the need to manufacture or purchase certain materials, and the suitability of accepting or rejecting an order based on the price and expected execution period., etc.

Any cost system’s main function is to determine, with the greatest possible precision, the production cost of the different goods and services created by the company. From the comparison with its sale price, the obtained Margin is obtained, which is fundamental information for decision-making.

Thus, allocating the different costs to their objectives is a key process of cost systems, so a cost system will be as good as its allocation process can be.

The ease of assigning costs, what we could call traceability, brings us closer to a first classification :

• We will call direct costs those whose relationship between the cost and the cost objective can be established clearly and easily. The amortization of production machinery could be a good example of this.
• Within these, we would have variable costs, whose main characteristic is that their total value changes with the volume of activity. A simple example, in this case, would be the raw material needed for production. It is noteworthy that the variable cost per unit usually remains constant as long as there is no change in the production structure.
• On the other hand, the so-called indirect costs are characterized because this traceability is either difficult to establish or impossible. In these cases, it is necessary to use Drivers or consumption measures based on cause-effect measures. A simple example here would be the distribution of the electricity cost to the production of different products; the kilowatt-hour consumption of each machine would be the Driver that would allow us to assign the electrical cost to its cost objective.

Although it is less precise than direct attribution, if the cause-effect relationship chosen for the distribution of indirect costs is good enough, a high degree of precision can be achieved.

Types of cost systems

Based on the concepts that we have just mentioned, the different cost systems have been configured, which we can group into two large general groups:

• Those who seek to analyze the Cost-Volume-Profit (CVP) model, whose objective is to study the variation in profit when changing the sales volume. These only take into direct account costs and, more specifically, variable costs.
• This way, the Coverage Margin per unit of product sold is calculated. This is the basis for decision-making regarding optimal production volumes to maximize profits or the actions to be taken when faced with changes in product prices or costs.
• The other group is the so-called traditional cost management model or Volume-Based-Costing (VBC), which seeks to assign all the costs, not only the direct ones, to the company’s final product. The relevant Drivers in this type of cost system are those most closely correlated with the production volume of the manufactured units.

Only production activities are charged directly to the final product. However, many indirect costs are not related to the product obtained, so they are allocated to their corresponding Cost Centers (which we can divide between the service and the main ones) to distribute water to the different products through the most suitable drivers.

The accuracy of the model depends on an adequate definition of the Centers. The main ones are those that intervene directly in the production process, while the costs assigned to the Service Centers are distributed to the main ones as a step before their allocation to the final product.

The biggest problem with the traditional model is that the drivers based on the volume of activity can rarely explain the distribution of costs to the Centers. For this reason, the values ​​distributed to the products from these Centres suffer from a lack of precision.

The Activity Based Costing (ABC) system considers the company’s activities, not just production activities. Therefore, the indirect cost is assigned to the product through the company’s different activities necessary, to a greater or lesser extent, for the production of the good or service.

How the process is carried out originates in the definition of activity as the set of tasks to obtain a product using resources directly related to it.

Activities consume resources, and Cost Objects consume activities, so costs are allocated to products proportionally based on the consumption of activities. Thus, we obtain more detailed cost information and a more precise allocation.

The ABC system or ABC analysis can also identify activities with less added value. This facilitates management decision-making: outsourcing of services, efficient application of resources, unit costs, prices, product mix, R&D investments, etc.

The costs allocated to the products will be different depending on the cost allocation method chosen, which will cause other effects both in the results obtained and in the valuation of inventories.

The problem of choosing a cost system depends on the required precision and the cost of obtaining the information. But there are also different types of companies adopting the ABC system that can be a greater incentive. Among them are those that maintain a high percentage of indirect costs, those that present a wide variety of products or services, those with a large number of activities, or those that bear high costs to obtain the necessary information.

Lately, the extension in the use of business information systems, as well as the greater ease in their use, open the door to new, more sophisticated, and useful cost systems for decision-making, significantly reducing the cost of obtaining information. But all of them are based on allocating costs through activities, so a good prior analysis is essential.