Using Activity-
Based Costing for
bottom-line results

By Gary J. Aschenbrenner, CPA

Activity-Based Costing (ABC) is a method of accurately assigning costs based on true resource consumption to products, services and customers. This methodology eliminates the "peanut butter spreading" of costs on an arbitrary basis. ABC is successfully being used today to:

I will review the application of ABC principles as used in my position as the finance manager of a manufacturing company. In any manufacturing company, costing involves the allocation of the total cost of a company’s manufacturing operation into individual costs of products produced during a period of time. Most accountants likely relate the acronym ABC to product costing.

The introduction explains that ABC principles have more potential applications than product costing. Another application is the subdivision of a company’s revenues and expenses into individual financial statements by departments of the company. We determined departments after identifying activities of the company that warranted unique reporting.

Revenues determined to have been earned by a department’s activities were assigned to that department and the operating expenses determined to have generated those revenues were likewise allocated to that department. Cash is the resource expended for operating expense costs such as wages, repairs, etc. We took the time to thoroughly study company costs so that operating expenses could be objectively assigned to respective departments.

Our company statement was divided into three basic departments: sales, manufacturing and administration. The sales department was further divided into retail and wholesale. Retail was further divided into locations and wholesale was further divided into salesperson territories and territories divided by customers within a territory.

Administrative expense costs that couldn’t be objectively allocated to a specific department were allocated to the administrative department. Administrative expenses are costs that benefit the company in general, such as company management, accounting, human resources, etc. It was determined that the benefit of the activities of the administrative department were equally shared by all other departments, therefore, management information was not enhanced by allocation of company administration to other departments.

Resource costs used by the manufacturing department were determined to include: raw material purchases, direct labor and overhead attributable to manufacturing. The manufacturing department statement presents costs of the resources used in manufacturing. The costs of goods that are manufactured in a period are transferred to the sales department.

Our company produces more than a dozen types of food products with some sold in various forms, package sizes and case counts that result in hundreds of product codes. It is an ongoing challenge assigning resource costs to so many cost objects or products. There is no such thing as an actual cost and the true meaning of a cost of a product for any given period is the average cost for the period (not the actual cost). In a true ABC Implementation the actual costs are allocated as accurately as possible.

So far it has not been feasible to apply ABC principles to inventory valuation for company financial statements and income tax returns. A traditional cost system is employed to determine inventory values used to prepare financial statements and tax returns. However, ABC accounting principles are applied in product costing for the purpose of determining the selling prices of products.

The use of automated spreadsheets has made it possible to create product bill of material templates, which automatically calculate a new product cost in a formula cell of the spreadsheet every time some variable in the template is changed. A bill of materials for each product includes variables for standard batch size, the standard quantity and cost of raw materials needed, the standard number of direct labor hours required and standards for manufacturing overhead cost application. In the templates multiple overhead rates can be used based on process and on variations in resources used for a specific product.

In manufacturing, raw materials go through unique production or processing stages before they become finished products. Our three main processes are raw material processing, finishing and packaging. There is variation in the exact work performed within a process depending on what specific product is going through that process.

Some processes rely more on labor than automation and other processes rely more on automation. One of two distinct packaging lines that our products may take utilizes much more sophisticated and expensive equipment. Automation makes the application of ABC principles more valuable.

A traditional cost system often uses direct labor time to allocate overhead costs. This method relies on the assumption that all products use equivalent labor hours but this is not necessarily true in our plant. Using incorrect assumptions in allocating overhead may lead to over pricing some products and under pricing other products.

We strive to protect ourselves from incorrectly costing or pricing for sale our products by maintaining an accurate knowledge of what resources products use when they go through the various processes of manufacturing. We have assigned costs to the resources used within a unique process so that we know what costs are incurred in raw material processing, finishing and two distinct packaging processes. In separating costs by process computer software in payroll allows employees to punch in under codes that designate a process and our depreciation software allows us to code equipment to achieve calculating depreciation expense for equipment used in a specific process.

We have set up our company’s chart of account numbers for general ledger accounting purposes to include an extension for departments, including sales by location, territory or customer and manufacturing by processes mentioned previously plus sanitation, warehousing, etc. We believe that the more accurate detail that we have, the more likely we will continue to be a successful company. ABC accounting has given us added assurance that we continue to make good financial decisions.