Introduction

Defining ABC

Convincing the Organization to Change

Introduction

Accurate and relevant cost information is critical to any organization that hopes to maintain, or improve, its competitive position. For years, companies operated under the assumption that their cost information actually reflected the costs of their products and services when, in reality, it did nothing of the kind. Over-generalized cost systems were actually misleading decision makers, causing them to make decisions inconsistent with their organizations' needs and goals, principally because of misallocated costs. Activity-based costing (ABC) is a valuable concept that can be used to correct the shortcomings in the cost systems of the past. It is a means of creating a system that ultimately directs an organization's costs to the products and services that require those costs to be incurred. ABC can be used this way because it provides a cross-functional, integrated view of the company, its activities and its business processes.

As a result, in many organizations, ABC has evolved beyond the point of simply developing more accurate and relevant product, process, service and activity costs. These organizations use ABC as a means of improving operations by managing the drivers of the activities that cause costs to be incurred. They are using ABC to support major decisions on product lines, market segments and customer relationships, as well as to simulate the impact of process improvements. Organizations involved in Total Quality Management processes are using both the financial and non-financial information of ABC as a measurement system.

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Defining ABC

The basic distinction between traditional cost accounting and ABC is as follows: traditional cost accounting techniques allocate costs to products based on attributes of a single unit. Typical attributes include the number of direct labor hours required to manufacture a unit, purchase cost of merchandise resold or number of days occupied. Allocations, therefore, vary directly with the volume of units produced, cost of merchandise sold or days occupied by the customer. In contrast, ABC systems focus on activities required to produce each product or provide each service based on each product's or service's consumption of the activities.

Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output. A unit or output (a driver) is used to calculate the cost of each activity consumed during any given period of time. An ABC system can be viewed in two different ways. The cost assignment view provides information about resources, activities and cost objects. The process view provides operational (often non-financial) information about cost drivers, activities and performance.

ABC does not only apply to manufacturing organizations: it is also appropriate for service organizations such as financial institutions medical care providers and government units. In fact, some banking companies have been applying the concept for years under another name—unit costing. Unit costing is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service.

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Convincing the Organization to Change

Implementation of an effective ABC system will never occur unless it is supported at all levels within the organization. Management must first be shown that existing cost accounting practices do not meet all of its cost information requirements. Management can then be shown how ABC can be used to effectively fulfill those unmet requirements. Management, particularly senior management, must be persuaded that ABC belongs on top of everyone's agenda.

In addition, the management accountants, who are traditionally responsible for the cost accounting system, must be convinced that the old methods no longer work and that an ABC approach is the solution, or the new system will be doomed to failure. Therefore, organization-wide education will be an important element in convincing participants to change, as well as effecting the change.

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