Activity Based Costing
“All we need is more sales and we can grow our way out of our cash flow problems!”
Sounds familiar? CEOs of underperforming businesses will often focus on winning incremental business, in the belief that boosting their top line will cure all cash flow issues. However, this mindset can prove fatal for companies in competitive markets which pursue clients or provide products and services without fully understanding the true contribution margin of the resulting revenue streams.
CFOs need timely and accurate information regarding customer and product profitability. However, reliance on traditional cost allocation methodologies may give rise to misleading information about the profitability of products, product lines, customers, and markets. In these situations, Activity Based Costing could be just the tool a CFO needs to make the correct strategic call.
Traditional costing limitations
Too often, gross profit margins generated using traditional cost accounting (and many accounting software) fail to reflect the total cost of provisioning a product or service. As a result, a CFO may have a false understanding of—a company’s break-even point, which products or services to deliver, which clients to target, or which costs to cut.
Top 5 costs typically mistreated
- Labour (particularly when salaried employees directly supervise projects)
- Distribution costs
- Rebates, commissions and selling costs
- Overdraft costs associated with late payment from customers
- Bad debts.
Activity Based Costing advantages
Activity Based Costing (“ABC”) takes a different approach. Using ABC, every activity associated with producing an item is determined and costed. Under the ABC approach many costs that traditional cost accounting treats as indirect – “below the line” costs – become direct costs.
The “full” cost for each activity is then assigned to customers, products or services that require or “use” that activity to determine the true gross margin. ABC can be a great tool for companies with significant overhead costs that deliver a wide range of products or services to a diverse customer base.
Top 5 reasons for using Activity Based Costing
- More accurate costing of products, services and customers – a better way to allocate overhead costs
- More accurate calculation of Gross Margin and break-even point
- Identifies less profitable product/services/customers
- Helps targeted cost rationalisation
- Supports decisions regarding pricing, adding or deleting products, retaining or dropping customers, choosing between outsourcing and in-house production, and evaluating process improvement initiatives.
Example of ABC in action
An importer and wholesaler of tile and stone floor coverings had traditionally sold the bulk of its products through a “big box” retail channel. Competition was intense, and the company’s profitability had slumped in recent years in the face of displaced volume and eroding margins.
In an effort to offset falling volume, the company sought to broaden its customer base by increasing sales direct to small independent home builders. However, despite improved revenues, profitability continued to decline.
The company undertook an ABC analysis and discovered that sales through the new channel were requiring significant incremental handling costs which materially impacted profitability. Using the ABC data, the company implemented price increases for new channel sales. Although volume reduced, the contribution from residual higher margin sales helped stabilise bottom line performance.
Warning flags – Situations calling for ABC
When should you consider implementing ABC?
- Production volume is increasing but profitability is declining.
- Product mix changes from lower to higher-margin products, but profitability declines.
- The business produces a mix of higher-volume standardised products or services and lower-volume customised products or services, yet the cost allocation system uses a single driver to assign overhead costs to products.
It is important to note that ABC does not change overall profitability in a company – rather, it better aligns the assignment of costs to the true causes of those costs. Armed with more accurate costing information, a company can make better decisions to improve profitability.