Conventional Driver-Based Activity Based Costing (ABC)

Recognizing the shortcomings of conventional absorption cost accounting, Activity-Based Costing has emerged as a tool whereby product cost distortion, as computed in conventional absorption cost accounting, was to lessened the inaccuracies of ACA. ABC was designed to eliminate the large cost pools and unrealistic allocation methods associated with traditional costing methods. However, the ABC system uses a two- stage process for allocating resource costs first to activities then, in turn, allocating activity costs to cost objects which also creates the potential for significance errors.

Stage 1: The first source of error. Resource costs are allocated to activities using resource drivers. A commonly used resource driver is the distribution of totaleffort expressed as a percentage of time or Full-Time Equivalents (FTE). The instructions per a major ABC software tool regarding activity costing…

Wages coming from the GL system will be allocated to activities according to the distribution of total FTEs associated with those activities.

The first source of error is the manner in which resource costs are allocated to activities. Given that the percentage of totaleffort is used to allocate resource costs to activities, perhaps a simple example will demonstrate the fallacy of this allocation method:

• A department has 4 employees.
  
• Total departmental wages are $400,000 per year.
  
• Each employee only performs one activity
  
• Since each employee represents 25% of total FTE effort, 25% of total wages (e.g., $100,000) will be assigned to the activities performed by each employee.

Although total department costs can be assigned to activities, the error within each activity is quite significant and becomes more inaccurate and misleading if additional activities are performed by the department (including shared activities among departmental employees along with cross-functional activities performed across departmental boundaries).

Stage 2, the second source of error. The manner in which activity costs are allocated to cost objects (e.g., LOBs, channels, customers, etc.). A single principal Activity Cost Driver (ACD) is identified for each activity and an average cost per ACD is computed and used to assign activity costs to objects based on the consumption of the number of drivers by each object. The two main issues associated with this approach are:

1. The selection of a single driver that represents the cost behavior of the activity when, in actuality, the activity may be influenced by a multitude of drivers whose costs can be defined as being fixed, variable, and semi-variable whereby ACD rates are typically treated as being 100% variable creating a linear relationship between volume and LOB activity costs.
   
2. The use of an average ACD rate. The ACD rate may be comprised of a wide dispersion of costs of which the average rate often is not representative of any individual product or service. As a result, LOBs receiving the activity costs in this manner will be either over- or under-costed.

Limitations/shortcomings of conventional ABC systems.

The following represents the most significant issues related to conventional ABC. Many of the advantages of ABC, over that of conventional absorption cost accounting, are offset by its disadvantages:

• Lack of process identification and activity dependencies. In most applications of ABC, a simple “laundry list” of activities are used which are void of their interdependent relationships. The lack of activity dependencies significantly limits the use of ABC for effective operational and financial management.
  
• Limited to financial measures only. Since the data source for ABC is typically the general ledger, the only measure of resource consumption is dollars. Selection of activities requiring corrective action based solely on cost is misleading as cost is not equivalent to value. However, measuring the activity “cost” in terms of the effort expressed in Full-Time Equivalents (FTEs) consumed in addition to dollars can uncover additional opportunities for improvement. The case study, found later in this document demonstrates the importance of “costing” activities in terms of both effort (FTEs) and monetary measures.
  
• Limited to financial measures only. Since the data source for ABC is typically the general ledger, the only measure of resource consumption is dollars. Selection of activities requiring corrective action based solely on cost is misleading as cost is not equivalent to value. However, measuring the activity “cost” in terms of the effort expressed in Full-Time Equivalents (FTEs) consumed in addition to dollars can uncover additional opportunities for improvement. The case study, found later in this document demonstrates the importance of “costing” activities in terms of both effort (FTEs) and monetary measures.

• Continued reliance on cost “pools.” Although ABC was developed to overcome the disadvantages of cost pools as used in conventional cost accounting, ABC continues to use pooling at the activity level. Since costs are pooled, aggregated, and blended by activity, individual resource cost components lose their identity. In addition to activity pools, other pools are created to facilitate the allocation of costs to activities such as utility and facility pools that are allocated to activities based on floor space or headcount. Whenever costs are pooled and distributed to LOBs on the basis of averaged transfer or ACD rates, individual LOB costs will be distorted – a result from over- and under-costing.

When the G/L is used as the resource data source, many of the accounts are often pooled and these costs are assigned to activities in total without any discrimination based on activities and LOBs supported by individual employees. The cross-functional nature of processes and activities across a multitude of LOBs, presents a major cause of cost distortion in ABC. The use of activity pooling in ABC creates the same issues as in conventional cost accounting for which ABC was originally designed to replace.

• Lack of necessary bi-directional audit trails. A required component of effective cost management is a good understanding of the origin and uses of resources. Since ABC uses a two-stage cost assignment process in which costs from the GL start out pooled and further aggregated by activity before such costs are allocated to objects, all individual resource identification is lost. As such, it is very difficult, or impossible, to determine which resources are associated with each cost object. With hundreds, if not thousands, of individual resource expenditures, the inability to trace the costs back from objects to their source, significantly limits decisions affecting product mix, staffing, divestitures, optimizing shared costs, process improvement, etc.
  
• Reliance on drivers to cost objects. Identifying and tracking a single primary activity cost driver is an arduous task and is often the most time consuming and expensive aspect of implementing ABC. Service companies whose output can often be described as intangible, find it most difficult to identify the drivers for those intangible activities. Driver identification and maintenance is required before ABC can be implemented and both the time and cost required to complete this task is often a major contributor to failure. There are a host of other issues related to the use of ACD rates to map costs from activities to objects:
  

- When computing ACD rates, quality, capacity, product mix, and productivity are often not considered and as such, ACD rates cannot adequately project future resource requirements.

- ACD rates are often treated as pure variable costs. As volumes increase, resulting costs increase proportionately. ACD rates do not often distinguish between fixed and variable costs. Consequently, ACD rates are not good predictors of cost behavior as volumes change – one major factor to management’s lack of support for ABC as a predictive tool.

- ACD rates are often computed over a fixed period of time and as such may not reflect the influences of seasonality, non-linearity, or other factors that may impact object costs. Also, since ACD rates are computed by dividing the activity cost by the volume of the driver, if the driver volume is not “normal” the rate will be either higher or lower than normal and unsuitable for product costing. Kaplan and Cooper (Kaplan, R.S. & Cooper, R. (1998). Cost and Effect – Using Integrated Cost Systems to Drive Profitability and Performance. Harvard Business School Press. Boston, Massachusetts.1998, pg. 279) stated the following with respect to the use of cost drivers:

“Actual activity cost driver (ACD) rates, whether calculated daily or monthly, are inappropriate to use for operational feedback and control. Nor should actual ACD rates be used for product and customer costing either… Managers who fail to understand the issues [associated with the use of cost drivers] may set inappropriate priorities for process improvement initiatives and make incorrect decisions about products and customers.”

• Lack of cost independence and weighted driver rates. To distinguish the differences in consumption of costs between various objects, some variants of ABC permit weighting ACD rates. Weighting ACD rates, in theory, isto ensure that the ABC system recognizes that some cost objects consume more of an activity’s cost than other objects. However, weighting factors are “relative” meaning that the weighting factor is based on a multiplier of what would be considered a “base” cost. In practice, when process improvements are made to one object, freed resource costs will be absorbed by the other objects – ABC systems are considered as closed systems adhering to a zero-sum-game process.
  
• Use of average costs. Identical to the issue cited under conventional absorption costing, the use of averageACD rates will over- and under-cost objects.
  
• Lack of intangible experiential information. Activity Based Costing has been used exclusively as a tool for furthering the understanding of costs and profitability of products and services. ABC is NOT a performance-improvement system. Using costs exclusively, without consideration of value as the basis for management decisions regarding performance improvement, will create a situation whereby “the wrong conclusions lead to the wrong solutions.” Similar to conventional cost accounting and a primary principle of Lean thinking, ABC is often void of customer and employee experiential input necessary to determine value.
  
• ack of prescriptive analytical tools. A singular tool used in ABC to identify opportunities for improving performance is identifying activities as being either value-added or non-value-added (NVA), targeting NVA activities for elimination. However, Kaplan and Cooper (Kaplan, R.S. & Cooper, R. (1998). Cost and Effect – Using Integrated Cost Systems to Drive Profitability and Performance. Harvard Business School Press. Boston, Massachusetts.1998, 1998, pg. 157-158) noted:
  

“Under careful scrutiny, people usually cannot consistently define what constitutes a value- or non-value-added activity… The dollars saved by improving the efficiency of a value-added activity are just as valuable as the dollars saved by improving the efficiency of a non-value-added activity.”

Oftentimes, as a result of the inability to identify the value associated with processes and activities, contemporary performance improvement efforts often improve processes that should not be performed at all.