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Activity Based Cost Management

How the activity-based methods can bring about constructive changes in financial control systems

Activity Based Costing is a method for developing cost estimates in which the project is subdivided into distinct, measurable activities or a work unit. It was an answer for the increasing lack of relevance of traditional cost accounting methods in the 1980s.

Activity based costing is not a financial accounting system, but an approach that measures the cost and performance of business processes and their outputs to provide a more effective way of viewing and interpreting information.

Like traditional cost accounting, activity based cost management is a cost allocation methodology. But there is a significant difference - unlike traditional cost accounting, activity based costing works on following principle:

Activities incur costs through the consumption of resources, while customer demand for products and services causes activities to be performed.

Basic flow of activity based cost management is as follows:

activity-base-costing1

Activity Based Costing Benefits

Activity based cost management has several benefits. As a business process improvement (BPI) tool activity based costing links elements such as process flow analysis, and performance management. This supports ongoing evaluation of effectiveness of improvement initiatives, including the activity based costing management endeavors.

By identifying cost pools, or activity centers, activity based accounting assigns costs to products and services based on the number of transactions involved in the process of providing a product or service. This supports managers to work out how to maximize shareholder value and improve performance.

Activity based cost management also helps in identifying the most and least profitable customers, products and channels. It also assists in determining the true contributors to- and detractors from- financial performance. Moreover, activity based cost management equips managers with cost intelligence to drive improvements.

Other benefits of activity based costing include accurately predicting costs, profits and resource requirements associated with changes in the organization. These changes might include changes in production volumes, resource costs and organizational structure.

Drawbacks

Activity Based Costing is a very helpful tool if your organization has clarity of methodology and the process under observation.

One major limitation of the method comes up when looking at using it for estimation of plans/budgets. It is next to impossible to have a proper estimation of the costs for some critical activities such as R&D. When proper estimation of the costs for one activity is missed out it results in breakdown in the whole chain of activities.

Another glaring drawback is that the potential for improved accuracy in product costs may be limited if the organization is already using multiple absorption rates in each production centre.

Conclusion

Activity based cost management has more advantages than limitations. When implemented properly, activity based cost management can bring about constructive changes in financial control systems.

For instance, when you carry out planning / budgeting with activity based costing you can always have more accurate estimations done. You can always work-out where your estimations went wrong, since you know what each activity contributed in your planning / budgeting.

However, the true benefit of activity based cost management is not that it is an improvement upon the existing accounting system. Activity based accounting provides the structure for the establishment of a true management-oriented system and therein lies its true benefit.