THE FINANCIAL STATEMENTS
KEY FINANCIAL INDICATORS
ACCOUNTING ISSUES
WHAT-IF ... SENSITIVITY MODELS
TIMING MATTERS
JUSTIFYING INVESTMENT
SCORECARDS AND VALUE MANAGEMENT

Cost Allocation

Activity-Based Costing

In an attempt to achieve a more accurate allocation of costs many companies adopted an approach called activity based costing (ABC). Production is divided into core activities. Each core activity has well-defined costs and these are applied to a product based on consumption of the activities. This means that each product is allocated only those costs which are directly relevant.

Thus, a highly complex product may not require many labour hours but it requires high salary engineers to oversee it, lots of computer-technology to manage the production process, rigorous testing and expert sales people. Under simple direct labour or machine hours’ calculations, it may be allocated too little overhead when compared to a fairly basic mass-production item. ABC, by calculating and assigning costs to activities allows true costs to be apportioned based on what activities are required for each product. The great benefit here is that one can clearly identify profitable and non-profitable products. It can also identify under-performing assets.

ABC is usually supplementary to the normal accounting of the firm. The mechanics of ABC are not as easy as abc. They can be extremely complex and implementation can often take several years. Much analysis of working patterns is required but unfortunately the world changes and so ABC is always playing catch-up. Once installed, human beings have a tendency to distort the processes. For instance, an engineer may have an unproductive day, tied up in meetings and waiting for equipment to arrive. Yet she must still allocate her time to an activity. So, following an initial burst of enthusiasm in the 1990s many organisations abandoned the challenge of translating theory into action. Robert Kaplan, one of the pioneering thinkers behind ABC, recognised the need for practical guidelines and published “Time-Driven Activity-Based Costing” in 2007, almost 20 years after his original article.