The ABCs of Activity-Based Costing

One of my favourite MBA classes has been managerial accounting. It's like solving little math puzzles and using them to make managerial decisions.  We've learned a lot this semester but one thing that is very useful is activity-based costing. I would like to take today's article space to explain the gist of this concept. I warn you in advance: For the first time since the Time Value of Money we may need to use... math.

The ABCs of Product Cost

If you're in business and you're selling a product or providing a service, it's important to know how much it costs.  If you know how much it costs you to make this product or provide this service then you can figure out how much you need to charge for it in order to make money.  Simple enough.

The product cost is made up of direct and indirect costs.

Direct costs: 

The cost of materials directly used in making the product or providing the service.  Broken down into Direct Material costs and Direct Labour costs.  So if you make footballs and use $1 worth of rubber and 10 minutes of labour at $12/hour to make one ball, then your direct costs for footballs are $3/ball.

Indirect Costs: These are costs that are difficult to calculate on a per-item basis.  It can be material that is hard to measure per item like glue or tape, or it could be electricity, rent, shipping, or other costs like these.  If you use $1000 of electricity in a month and make 10,000 footballs with it, you can't tell if one actually used more electricity than the others.  So you just "apply" these overhead costs to the products instead.  In this example we might just divide up the costs evenly and add $.10 to the cost of each ball.

So in the end the general rule is your product cost is your direct material, your direct labour and your manufacturing overhead all added together.  Or:

PC = DM + DL + Overhead

Applying the overhead

The easiest way to apply overhead is just divide the total by the number of labour hours your employees worked in a year. This gives you a "plant-wide rate".  Then you apply the overhead based on the number of labour hours a product takes to produce.

So if you have $120,000 of overhead, and you have 10 employees working 2000 hours each, the plant-wide rate will be 120,000 / 20,000 or $6/hour.  So your footballs that take 10 minutes each to produce would have $1 of overhead applied to each.

The problem

Overhead = electricity, heat, managers' salaries, incidentals, etc.

If all you know about your products' costs is the overhead applied using a plant-wide rate, it's impossible to find out where the inefficiencies are.  Your reports at the end of the year would show what you spent on  materials, labour, and overhead, but they wouldn't show you how much each product used.

In addition, most companies sell more than one product. They might consume overhead resources at different rates.  If you stared making cars in the same plant that take a machine 6 hours and $1000 worth of electricity to produce, but only 10 minutes of an employee's time to set up the machine, you'd only apply the same $1 of overhead to the cost of the car.

At the end of the year you'd find your total overhead was much higher than you'd anticipated, and it would be divided evenly between your footballs and your cars. You'd end up with a very skewed picture of how much each actually costs to produce.

Did this football really cost $5000 to make?

ABC costing

The solution to this problem is to break the overhead costs into categories and see what is the "driver" of each cost.  You'd then be able to apply the overhead costs more accurately.  More importantly, you would know where all your money is going.

So for example, if your overhead was $120000 broken down into $100,000 of electricity and $20,000 in coffee for the workers, you might apply the electricity based on the machine hours and the coffee based on direct labour. This scheme would put more of the overhead onto the cars, and allow you to see exactly why - the cars used more machine hours, which, in our example, drink electricity like a thirsty camel.

If you wanted to control costs under the old scheme, all the overhead was based on Direct Labour.  The only tool you had to control costs was to reduce Direct Labour, aka lay people off.  With ABC we can see that most of the overhead is electricity, so to control costs we might look into switching machines, finding more efficient processes, or negotiating better power rates.

Now I know my ABCs

Now I do apologize for one thing.  I wrote this whole article trying to illustrate product costing, and I realized at the end that I probably should have explained one consistent example from beginning to end instead of trying to explain concepts and highlight them with fake numbers.  I hope it wasn't confusing but I'm not changing it now.

This subject came up today because my managerial accounting professor was talking about the student protests over tuition rates. The government is raising tuition, trying to get more money, but a more effective solution might be Activity Based Costing. If this were implemented in the hospitals and universities, more than likely there would emerge all sorts of ways to cut costs and make them more efficient. Isn't that interesting?