What causes any differences between costs and profitability between traditional and ABC systems?

Introduction

Changes in market behavior have made traditional costing methodologies obsolete. Given the market’s great competitiveness, with ever slimmer margins, how can costing systems be designed to inform more assertive decisions and maintain business profitability?

It was within this context that Activity Based Costing, or ABC first appeared. The ABC system is based on the analysis of specific costs related to every activity performed by a company in the manufacturing of its products or services. Based on these activities, resources are allocated to various products, services, markets, etc., generating a clear vision of the company’s costs. In this manner, the company has a more precise view of the impact of each activity on the operational costs of the business, facilitating more adept management of its profitability.

Origins and Development of Activity Based Costing

Studies and documents demonstrate that the ABC system was first employed to some extent by large American industrial firms in the 1950s. However, this methodology was only promoted and popularized by studies conducted by Professors Robert Kaplan and Robin Cooper in the United States at the beginning of the 1990s.

These two professors perceived that for a series of reasons that we will present below, the method used to cost various products and services no longer reflected organizational reality and was causing great distortions and great harm to company results.

In their studies, Professors Kaplan and Cooper identified 3 independent and simultaneous factors which justify the implementation of the activity based costing system:

1. TheModification of the Cost Structure since the 1950s

The fact is that the cost structure has changed drastically over the past 50 years. In the past, labor costs represented 50% of total product costs, followed by raw materials at 35% and overhead costs of 15%. Today it’s not uncommon to see overhead costs represent 60% of product costs, raw materials average 30% and labor costs represent less than 10% (in service and government organizations the overhead is even greater). This is why using the number of labor hours to assign allocation of costs made sense until the middle of the twentieth century, but today it makes no sense given the current cost structure.

1. Competition

The number and quality of competitors has changed greatly in recent years, which has resulted in cost margins diminishing year after year – making it that much more important to control costs well. Within this context, the implementation of the ABC costing methodology promotes a greater control of costs, making it possible to increase competitiveness due to better profit forecasts.

1. Fall in Implementation Costs

The cost of implementing/measuring has fallen greatly due to advances in, and the wide availability of, information technology. In the past, the cost of implementing an effective ABC costing system was prohibitive, and was possible only for companies with access to large applications running on large computers and mainframes.

With the development of computational technology, this methodology has become accessible for a large number of organizations. Thus, the main reason why this costing system became popular after the articles published by Professors Kaplan and Cooper was that advances had taken place in both hardware and software.

These technological advances made it possible for the system to be taken off the drawing board and put into practice, mainly in the implementation of costing models for more complex organizations which require greater detail.

The trigger missing for the popularization of this methodology was the rise of micro-computing at the end of the 1980s and the development of software GUIs through operational systems such as Windows (Microsoft), OS/2 (IBM) and Mac (Apple). With these events, applications that previously could only be run on large computers and mainframes could now be run by any organization and were accessible to a wide variety of users and departments.

Thus, today many organizations in the manufacturing, government, service, telecommunications, banking and logistics sectors have used this methodology with success. Its use, contrary to what many imagine, has not been limited to large corporations and has spread to many medium and small companies in both the public and private sectors.

We’ll show you everything you need to know about this system, including its advantages and how to implement it. Take a look!

Differences between ABC Costing and Traditional Costing Systems

Traditional costing systems arose to meet tax requirements and stock valuations, but these systems have various flaws, especially when used as management tools.

This happens because these traditional costing methodologies are focused on the various products that companies offer. Costs are assigned equally among these products because it’s assumed that each item/sku consumes the organization’s diverse resources in proportion to the volume of the products produced.

In this way, various “volume” drivers such as direct labor hours, machine hours and raw material allocation of costs are used as criteria to assign overhead costs.

This methodology means that these values only reflect an estimated average. Even though a complex study is used to arrive at this calculation, this is a scenario that by definition will never correspond exactly to the specific characteristics of each company and its individual processes.

These volume based drivers also fail due to the diversity in the form, size and complexity of these products. There’s also no direct relationship between the production volume and the effort or costs consumed by the organization.

As a result, many managers of companies that offer a variety of products and services are making very mistaken decisions in terms of prices, their mixes of products and services, and their processes.

The Efficiency of Activity Based Costing

In contrast to traditional based costing systems, activity based costing focuses on an organization’s various processes and activities. In addition, there are differences of treatment in terms of the various clients, channels, markets and regions that are often ignored by companies– and which later prove to be fundamental to making an assertive decision.

Initially the costs that originate from every activity of the company are tracked. Then these costs are assigned and the manner in which the final bearer of each cost has consumed the services of each activity determines how these costs are allocated.

Thus, these varied costs are assigned to a variety of activities for all of the Products, Clients, Channels, etc. based on the use of each of these in the organization’s activities. This way the Overhead is assigned in an appropriate manner always respecting cause and effect relationships and not using “volumes” as a basic criterion for equal distribution.

Once the costs of the activities have been determined, the organization can begin to manage them and question why each is affecting the costs of the company’s various products, clients, channels and services. At the same time, this system makes the costing process more accurate and precise.

Focus on Activities, not Products

What makes this costing model an extremely efficient methodology is that it begins with thinking about the issue of costs. What was treated in other models as an indirect cost linked to the product is now treated as a direct cost. The focus shifts to the activities performed rather than the products associated with them.

The key point is that the fact that each product, service, client or channel is the result of a variety of activities that, if treated individually, have a greater chance of providing specific data that can be converted into more exact values.

The Key is Cost Tracing

The efficiency of this costing methodology is in its ability to provide a logical tracing of costs. The fact that it isn’t linked to the timing of each process makes it possible for ABC costing to identify each expense and designate it as part of a specific activity.

In this way, even if certain expenses are grouped within the same cost center, they’ll be organized according to the activity to which they’re linked.

This optimization of cost control brings countless benefits to all of the company’s departments as we’ll show below.

The Advantages of Using Activity Based Costing

A series of advantages come from a company’s implementation of ABC costing which go beyond the accuracy of the definition of the allocation of costs of products, services, clients and channels.

We’ll discuss some of the most important ones to clarify how it increases a company’s profitability and decision making ability.

More Precise Information

As soon as the cost model is created, with well-thought out assignment criteria and future implementations established – you’ll have better and more precise information available for your decision making.

This makes the company’s planning and decision making more accurate. Managers have a better idea of future profits and spending as well as data that will enable them to make efficient decisions in terms of product and service pricing, product mixes, outsourcing or internal development, research and development investments, automation, marketing, campaigns and much more!

A Better View of Your Process Flow

Here we can mention not just more transparent cost data for each department, but also a review of internal controls and greater visibility for every process.

As the company gathers more information about its processes and their influence on the company’s products, services, clients and channels, it will be able to make more assertive decisions. This provides each manager with more tools to manage the team’s costs as well as information to audit and analyze these costs.

With an understanding of the costs of each activity, these managers can make decisions based on business processes and activities. In addition to this, once these activities have been mapped, labels with attributes can be associated with each one making it possible to study whether they add value or not.

Reducing Costs

The description of the specifics of each process and its costs makes a multidimensional analysis with a panoramic (global) focus on the costs of each activity possible. In this way, greater than expected costs can be identified and the budget can even be revised to eliminate expenses that are revealed to be greater than necessary.

Thus, reducing costs becomes just a question of time, because each manager has access to more precise information to analyze these processes.

It should be remembered that more effective cost control is something that makes this methodology efficient for small and large companies, no matter what their sphere of operations.

Implementation

The implementation of an ABC Costing system may seem complicated, and it will vary somewhat depending on the size and complexity of the activities, products and services of each company.

But to simplify the process and implement the ABC methodology in an efficient manner, you can use the following list of steps as a reference.

They apply to companies of all sizes and business models, and help in the creation of a budget based on activities that promotes greater cost control and profitability for your organization.

1. Define the Implementation Tool

A sophisticated cost model requires a specific system. Many companies already possess a costing mechanism that uses spreadsheets. Others try to customize their ERP or even believe that BI can solve cost management.

However, the accounting and consulting firm of Ernst & Young (EY) in a recent article recommended none of these options. According to EY, “the model can be developed using Excel, Access or internal development, but this can only be done for very simple models, and even these models are extremely limited when more elaborate analyses are required. This doesn’t even mention the issue of integrating such as system with other company systems, cost tracing, model auditing and the integrity of the data itself.”

In terms of an implementation using an ERP, we know how expensive and complicated it is to customize these systems. In addition, their static and cumbersome nature doesn’t provide the flexibility required for an implementation of this kind.

In terms of BI systems on the other hand, these systems present information that already exists within the organization, but we know that cost modeling requires profound transformations in terms of assignments, including reciprocal costs, and the understanding of multiple levels and dimensions, which is something that is not easily done or practically impossible to implement within a BI system.

Eliminating these practical implementation problems, the MyABCM product suite is the global leader in cost management solutions. With its multidimensional analyses, organizations can use it to model, analyze, and create simulations with great flexibility and security providing full integration with the organization’s corporate systems.

1. Determine the Project’s Objectives

Here it’s important to understand what you’re seeking through a project of this nature: you want to determine the costs of products? Clients as well? What about channels? Markets, regions, projects? There are many possibilities.  Within this context, one of the greatest mistakes that can be made is to begin modeling and then change one’s assumptions in the middle of the project.

In addition, another important point to be considered is creating an implementation agenda with clear definitions of the detail to be adopted and possible criteria and implementation milestones and ideas.

1. Map the “Intelligent” Activities

This part of planning is fundamental to the efficient implementation of the model. It’s not unusual in projects of this kind for managers to want to map hundreds, thousands, and sometimes even tens of thousands of activities, frequently reaching the level of tasks.

This is a very inefficient way of working, since mapping many activities will certainly involve a lot of effort for relatively little gain, especially for activities that are not very relevant. In addition, using very complex modeling from the outset will make the initial integration of the model with other corporate systems a great challenge.

The best practices of implementation include the ability to model in stages, with complexity increasing as the model evolves, while always bearing in mind the relevance of what is being mapped. According to Gary Cokins, one of the foremost experts in Cost Management, “organizations should question whether the activity’s important and relevant to the company.”

1. Define your Resources Well

Here you need to define your initial costs, expenses, cost centers, accounts, possible groupings (Cost Pools) that you should establish, and the Revenues which will provide the initial Resources to be assigned.

1. Define the Various Assignments

This part of the planning is important because it ensures that each Resource is linked to a process which is identified by its relationship with the activities linked to a product, service, client, channel or project.

1. Determine the Drivers

Once your Resources and Activities have been defined, determine the cost drivers you wish to use and the criteria for each one.

This way the calculation process will be coherent because it will represent a cause and effect relationship between the cost source and destination.

1. Calculate the Model and Create Reports and Analyses

Once the model is defined it’s time to perform the calculation, generate simple and complex data cubes (which will later make it possible to conduct various analyses using dynamic tables), and create simple and advanced what if scenarios.

With your application and report analysis, your system can evolve, which will affect the effective tracing of more and more of your company’s activities.

Conclusion

The implementation of an ABC Costing system offers you greater control of your organization’s costs. This methodology develops tracing and allocation models that identify the allocation of costs related to each activity with precision as well as how they affect your company’s profitability.

In this way, it’s possible to construct an efficient management system based on activities, making it possible to reallocate resources and make a structural reduction of costs, promoting greater profitability, even within scenarios that are more and more competitive.

In addition to this, this system makes it possible to make assertive decisions with assurance in terms of pricing and the analysis and control of products, markets, channels, clients, etc.

Thus, your implementation will culminate in greater profitability in the middle and long term through a detailed vision of organizational processes and will also result in an increase in your company’s competitiveness.

With these tips you can implement an activity based costing methodology in a way that will make this process more efficient and help your company grow more and more.

Within this context, MyABCM’s software has been developed to provide management based on activities, favoring cost control and your business’s return on investment.

Thus, using a system like the MyABCM solution surpasses the activity and cost management capabilities of any other software. Our systems are developed to meet the specific needs of every size of business and offer the allocation of resources in multidimensional analyses that contemplate all of your company’s relevant activities, can be adjusted for any level of complexity, and make it possible for you to constantly evolve your costing models.

Want to know more about our solutions and how the ABC methodology can help your business become more profitable? Find out about our successes and get in contactwith MyABCM to answer any doubts you have and receive all the support you need to apply this methodology!

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