Activity Based costing

ABC

Even though ABC18 employs a slightly different terminology and another set of thoughts in distributing the costs than does the contribution margin model, the issues at hand are similar: relating the firm's costs to earnings-producing activities.

When a decision concerning pricing or product mix is about to be made, it is essential to know which costs belong to which earnings. If the costs are not in one way or the other contributing to the production of earnings, they may in an economic sense be superfluous. For instance, surplus capacity is a superfluous cost. The purpose of ABC is among other things to identify superfluous activities (=superfluous costs).

It may appear to be a very narrow economic perspective, but ABC is not constructed to stand alone or to be the sole basis for decision making. It is a tool for inspirational analysis, contributing with an estimate of the cost related consequences of the firm's activities.

Cost pools / Cost centers

Resources are divided into cost pools (some writers use the term cost centers). Cost pools are for the specific firm defined so that every cost defrayed can be attributed to a cost pool. Examples of costs pools are employees, locations and information systems. Cost pools are always defined in DKK, which emphasize the direct connection to the firm's costs. A cost pool is typically controlled by a decision maker, responsible for the size and progress of the costs.

Cost objects

Cost bearers are in the ABC terminology called cost objects. Examples of cost objects are customers, groups of customers, product groups, and orders. Thus the term is closely aligned to what is traditionally referred to as division of purpose. Like cost bearers, the cost objects can be half-manufactured products and products that are traded internally in the firm.

A prudent connection between the cost centers and cost bearers corresponds to the creation of a rational linkage between cost pools and cost objects. However, it is not meaning that the cost pools and cost objects are to be combined one by one, the cost pools are too broad for that. The specific cost pool is to be distributed to several cost objects, and thus ABC can be conceived through a refined distribution key, supposedly less arbitrary than the traditional models.

Cost drivers/ Activities

The coherence between cost pools and cost objects is created by a link called a cost driver / activity. An activity is an action that draws on one or more resources, i.e. cost pools. This joining must not be confused with the activity term in the contribution margin model, where activity is an expression of the firm's output level.

The coherence between the central terms mentioned above is shown in the figure below:

As is the case of cost pools and cost objects, the activities have to be categorized in sensible way, if the coherence of the different terms is to be found in practice. Johnson and Kaplan, who introduced ABC in the end of the 80s, are very specific when it comes to categorizing the activities. They suggest four main groups of activities:

o Unit determined activities: These are directly determined by the production of a specific product unit. A product unit is typically a good or a service, and examples of the corresponding activities are consumption of raw materials, consumption of power, and the working process, that is directly related to the specific unit.

o Activity series: i.e. activities that are directly determined by the production of the particular product series. Costs that are caused by activity series do in principle not vary with the number of units produced in each series. Typical activity series are: reorganization of machinery for a new series, or quality control of a given existing series.

o Product preserving activities: This group of activities is tied to the particular product types and models. Thus the activity is independent of how many product series the specific product type is produced in, and the quantity of units produced. Examples: product development and product design.

o Business preserving activities: ABC operates with "the rule of one": Some activities, such as top level management and auditing are necessary no matter how much is produced in the company. Broadly speaking, these activities do not vary with the number of units, series, and products that are produced in the company, and as such they are irrelevant to distribute.

It is reasonable to consider the unit determined activities in the ABC equal to the variable costs from the contribution margin model (not to be confused with variable costs from the cost theory). In both circumstances, the terms vary wholly with the particular product. However one should be aware of the differences of activities in the ABC and costs in the contribution margin model. Activities are actions that can not be fully determined financially, whereas costs are always listed in kroner and 0re. Herein lies ABC requirement for some kind of distribution key in order to distribute the activities between the cost pools that represent the costs.