Small- to mid-sized businesses (SMBs) are no stranger to the challenges of managing costs and maintaining profitability, especially in periods of economic uncertainty. Activity-based cost accounting (ABC) helps your organization establish the true costs of your products, services and processes. A thorough understanding of the realities of your cost structure enables you to make the most efficient and profitable business decisions.
Understanding the Fundamentals of Cost Accounting
Cost accounting is a critical component of revenue generation. When using activity-based costing, your business must track the costs of all the resources required to produce your products or services, and then assign overhead costs accordingly. By adopting this approach, your organization can ensure your bids and estimates accurately reflect the true cost of production.
Direct vs. indirect costs
The first step in activity-based costing is to differentiate between direct and indirect costs.
- Direct costs can be immediately tied to a specific product or service. For a publisher, for instance, the paper required to print books is a direct cost.
- Indirect costs include items that are generally considered overhead, such as rent or utilities.
Direct costs are usually variable: the more books a publisher prints, the higher the paper cost will be. Indirect costs like rent are usually fixed.
Fixed vs. variable costs
Costs can also be categorized as either fixed or variable.
- Fixed costs stay the same, regardless of how much the business earns or produces. Rent is an example.
- Variable costs fluctuate according to business volume. The cost of raw materials is a good example.
Some expenses, like labor costs, can be semi-variable: the cost for salaried workers is fixed, but the cost for commission-based or hourly workers may vary by sales or production volume.
The role of cost accounting in decision-making
Accurate cost accounting plays a critical role in strategic decision-making. By understanding the true costs associated with operations, your business can price your offerings competitively, identify opportunities for cost optimization and make informed investments to drive profitability.
Limitations of Traditional Costing Methods
While traditional cost accounting methods like job order costing and process costing have their place, they often fall short in providing the granular, actionable insights modern businesses require. These methods rely heavily on broad overhead allocation, leading to less accurate assessment of what projects will truly cost, which can lead to over- or underestimations and potentially misguided decision-making.
As your business becomes more complex, with a wider range of products, services, and supporting activities, the limitations of traditional costing become increasingly apparent.
Activity-based cost accounting is often used in the manufacturing industry to increase the accuracy of job estimates and quotes, eliminate inefficiencies and drive profitability. There are several other internal costing techniques, including:
- Job order costing assigns costs by each job, which is useful for businesses in which each project has unique characteristics.
- Process costing assigns costs for mass-produced or near-identical products.
- Marginal costing calculates the cost of producing one more item or unit, to determine the optimal point for economies of scale.
How activity-based costing differs from traditional costing
Traditional costing methods use metrics like piece volume or labor hours to assign overhead costs to products/services. For example, they might use the number of labor hours worked to assign energy costs.
On the other hand, activity-based costing divides production into individual activities and assigns overhead to each of those activities in proportion to the resources each activity consumes. Activities are sorted by batch-, customer-, organizationally sustaining–, product- and unit-level. Each project can assign costs focused solely on the activities required. This provides a more accurate and actionable view of your cost structure.
Advantages of Activity-Based Costing
Activity-based cost accounting provides a more precise, and therefore actionable, understanding of the true costs associated with your products, services and processes. This is because it shifts the focus from arbitrary overhead allocation to a deep understanding of the specific activities and cost drivers that underpin your business.
This visibility has a profound impact on your company’s ability to predict activities required for different types of work and assign appropriate resources. You can also identify and eliminate inefficient or unnecessary activity, optimizing overall costs and improving your bottom line.
Putting Activity-Based Cost Accounting Into Practice
Transitioning to ABC takes time and is a collaborative managerial accounting effort, but the payoff can benefit your entire organization.
Step 1: Identify activities and cost drivers
This vital step involves working closely with multiple stakeholders to identify all the activities involved in your company operations, from product development to customer service. Be sure to include any that may go unnoticed or assumed, such as training, prep time or breakdown. Once you have this comprehensive list, determine the relevant cost drivers for each activity.
Step 2: Assign costs to activities
At this stage, assign the appropriate costs to each activity. This may involve complex calculations, as resource consumption needs can vary dramatically between projects or products.
Step 3: Allocate activity costs to products or services
Only allocate costs to the activities used in the project or product, in proportion to the resources the activity consumes. By identifying how much each activity proportionally contributes to revenue production, your company can eliminate inefficiency and concentrate on the most profitable activities.
As an example, one project might involve extensive training. Another might require many machine hours. Although the number of hours might be the same, the activities are quite different. Assigning costs by activity rather than hours would provide your business with an accurate view of how and why you spent money.
Use ABC to Drive Profitability
Cost accounting is crucial to ensuring the profitability of your business. Activity-based cost accounting takes this discipline to the next level, making sure you fully understand how your work activities contribute to revenue and enabling you to assign overhead costs proportionally to each.
By implementing ABC, you can significantly improve the accuracy of your bids and quotes, which will help you gain a leg up on the competition. This approach will also reveal opportunities to streamline your workflow and identify the activities most closely linked to revenue and profitability.
Of course, transitioning to activity-based costing isn’t always a simple process, especially for SMBs with lean finance functions. Paro can match you with a highly skilled fractional or project-based accounting expert if you need guidance on ABC implementation so you can develop a complete understanding of your true costs.
