March 28, 2006
The ABC’s of Activity Based Costing
Activity Based Costing has helped many food distribution companies provide the answer to the age old market’s need for better quality products at competitive prices. The ABC method allows management to more effectively analyze both customer profitability and product profitability. This in turn allows companies to improve their efficiency and reduce costs, without sacrificing the value of the item for the end consumer.
The most commonly seen benefits with an Activity Based Costing system include:
· Identifying the most and east profitable customers, products, and channels
· Determine the true contributors to and detractors from financial performance
· Accurately predict costs, products and resource requirements associated with changes in production volumes, organizational structure and resource costs
· Easily identify the root causes of poor financial performance
· Track costs of activities and work processes
· Equip managers with cost intelligence to drive improvements
· Facilitate better marketing mix
· Enhance the bargaining power with the customer
· Achieve better positioning of products
· Improved means of identifying high overhead costs per unit and finding ways to reduce the costs
*Next week’s issue will focus on real life examples of Activity Based Costing as they pertain to the bolded benefits listed above.*
Fact or fiction? It is believed that high volume customers are profitable customers, a loyal customer is also a profitable one, and profits will follow a happy customer. If you said fact you wouldn’t be the only one, however studies on customer profitability have revealed that the above is not automatically true. ABC is a costing model that identifies cost pools in an organization and assigns costs to products (cost drivers) based on the number of events or transactions involved in the process of providing a product or service.
As seen in the above chart, the way it works is first major activities are identified in the process system. Next cost pools are created for groups of activities that can be allocated together. Following this cost drivers are identified. The number of cost drivers used varies depending on the balance between accuracy and complexity. After determining cost drivers, rates are calculated. The rates are then applied to the respective cost drivers for each product that is being considered. The overhead cost per unit is then derived by dividing the total cost for the product by the total product units.
Keep in mind that ABC is not a software package but a costing methodology that can be supported with a software package. Also one of the basic issues with ABC however, is the intricacy of implementation. It takes a lot of effort and can be very time consuming to categorize the activities and processes to be allocated properly. Just as anything else, ABC should not be embraced as a cure-all or a fad. It is an operational strategy that needs to be cautiously reviewed for applicability. ABC makes the most sense for companies with several products who are suffering from inaccurate costing information and need to know which products are truly winners and which ones are really losers. If your company falls into this category then the money and time spent on ABC implementation will be well worth it. Overall ABC is a useful tool that provides a means to measure and control key strategic priorities to reduce costs and develop economic incentives to encourage the end user to pull products through the distribution network improving the over all efficiency of the supply chain.
ABC Helps Identify & Eliminate Your True Costs
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