Activity Based Costing
Student Name : Firas Ahmed Abussaud
ID # 934581
INTRODUCTION
In order to achieve the major goals of business process improvement,
process simplification and improvement, managers need to fully understand
the cost, time, and quality of activities performed by employees or machines
throughout an entire organization.
In a traditional cost system, contractors assign material and labor costs to
various lobs by specific identification. Certain other costs, usually referred
to as overhead, come from a variety of sources and are allocated among
various jobs as a percentage of labor. However, many other costs are usually
not
purchasing,
job-costed.
estimating,
sales
Examples
and
promotion,
are:
invoicing,
payroll
administration, and supervision. Therefore, these costs are grouped with a
category called “general and administrative” and are costed as percentage of
the direct labor or material cost. “Activity Based Cost (ABC) theory tells us
that this typicaL costing procedure often creates an erroneous picture of how
well a company is performing (Matteson, K, et al, 1993).
Nowadays, there is a decline in the centrality of labor as a primary cost in
producing services as a result of the increased use of automation and
computerized services. Therefore, relying on direct labor hours (or any
simple allocation basis) as the primary cost allocation basis can produce
large distortions in the allocation of overhead costs. The need for more
accurate costing for products and services has ed to the widespread adoption
of activity based costing (ABC) (Snyder, H. and Dovenport, E., 1997).
Although the literature has reported numerous implementations of ABC in
different types of firms, there has been limited accounting of ABC being
embraced by construction firms.
The objective of this paper is to present the idea of Activity based Costing
(ABC) and to introduce some areas in the construction industry that it can be
implemented. Literature was reviewed to strengthen and to enhance the idea
proposed.
ABC is an advanced tool that is used for cost management purposes. ABC is
a process for measuring the cost of the activities of an organization.
Activities within an organization are identified and an average cost is
associated with each activity. The total cost of a product is the sum of the
costs of activities required to bring forth, sustain, and retire the product. The
cost of an activity for a product is defined as the average cost of the activity
times the number of times the activity is required for that product (Dean, E.
B., 1993). According to Kyj, L. S. and Pritcbard, R. E (1996), ABC was first
implemented by General Electric finance and production managers during
the 1960s. They described work that causes costs to be incurred as
“activities” and that is where the name activity based cost came from.
However, the first organized implementation of ABC was pioneered by
Robin Cooper, Robert Kaplan, and Thomas Johnson in 1988. They wrote
many articles about this topic (Roztocki et al, 1999).
General Electric’s team discovered, as part of the work that Ted to the
development of ABC, that many indirect costs associated with the
manufacturing process resulted from decisions made in other departments.
Yet the existing cost accounting system resulted in charging indirect costs to
the department that incurred them rather than to the department that caused
them (Kyl, L. S, 1996).
For example, an engineering design change is a typical situation in which
one department causes costs to be incurred in another department. Indeed,
such a design change, even a relatively minor one, might cause changes in
blueprints, bills of material, material ordering specifications, and quality
control. The costs of these changes are generally classified as indirect costs
(Kyj, L. S, 1996).
ABC is an essential part of the functional process improvement and
reengineering effort. It captures quantified cost and time data and translates
this into decision information. ABC measures process and activity
performance, determines the cost of business process outputs, and identifies
opportunities to improve process efficiency and effectiveness. Qualitative
evaluation and determination alone is inadequate as a single measure of
improvement. Though quality might determine “better”, it does not
contribute to other meaningful decisions such as what is “cheaper” and
“faster”? It is the integration of these two dimensions (efficiency and
effectiveness) that is the critical decision support element of the total
process. ABC is the mechanism to integrate these two views (Website-3).
The decision-maker is always faced with difficult choices and multiple
alternatives. Though decisions can be made with feelings and intuition, this
is not the predominant situation. ABC identifies and quantifies activity cost
and performance data into a format that stratifies decision variables into a
configuration that makes the decision clearer and easier to make (Website3).
ABC systems give managers a more strategic view of their business by
helping them understand the sustainable economics of making products and
serving customers. ABC systems trace costs from resources (people,
machines, and facilities) to activities and processes and then to specific
products, services and customers (Cooper, R., and Kaplan, R., 1998).