HOW ACTIVITY-BASED COSTING WORKS

Activity-based costing programs require proper
planning and a commitment from upper management.
If possible, it is best to do a trial study or test run on a
department whose profit-making performance is not
living up to expectations. These types of situations
have a greater chance of succeeding and showing
those in charge that ABC is a viable way for the
company to save money. If no cost-saving measures
are determined in this pilot study, either the activity based
costing system has been improperly implemented,
or it may not be right for the company.

The first thing a business must do when using
ABC is set up a team that will be responsible for
determining which activities are necessary for the
product or service in question. This team should include
experts from different areas of the company
(including finance, technology, and human resources)
and perhaps also an outside consultant.
After the team is assembled and data on such
topics as utilities and materials is gathered, it is then
time to determine the elements of each activity that
cost money. Attention to detail is very important here,
as many of these costs may be hidden and not entirely
obvious. As Joyce Chutchian-Ferranti wrote in an
article for Computerworld: ‘‘The key is to determine
what makes up fixed costs, such as the cost of a
telephone, and variable costs, such as the cost of each
phone call.’’ Chutchian-Ferranti goes on to note that
even though in many instances technology has replaced
human labor costs (such as in voice-mail systems),
a business manager must still examine the
hidden costs associated with maintaining the service.
Nonactivity costs like direct materials and services
provided from outside the company usually do not
have to be factored in because this has previously
been done.
Once all of these costs are determined and noted,
the information must be input into a computer application.
Chutchian-Ferranti explains that the software
can be a simple database, off-the-shelf ABC software,
or customized software. This will eventually give the
company enough data to figure out what they can do
to increase profit margins and make the activity more
efficient.
After a business has had enough time to analyze
the data obtained through activity-based costing and
determine which activities are cost effective, it can
then decide what steps can be taken to increase profits.
Activities that are deemed cost prohibitive can then be
outsourced, cut back, or eliminated altogether in an
effort to make them more profitable. The implementation
of these changes is known as activity-based management
(ABM).