Around 2015-16, two Indian researchers studied an Indian steel plant. They augmented and enhanced an existing costing model called activity-based costing (ABC) in the steel plant’s raw material handling department. With the help of this developed model, the researchers identified ten key activity pools, such as reclaiming, stacking, conveyor belt movements, etc., assigned resource costs to them, and allocated activity costs to those activities. This approach was more detailed and accurate cost information than the one provided by the traditional costing system used in the plant. It helped the steel plant analyze the impact of the various activities in the steel plant and eliminate the ones that added no value to the raw material handling department. The all-new ABC model improved the steel plant’s productivity and profitability.

This is just one example of how ABC has helped companies manage costs and improve operations. There are many more, and we will explore them in detail soon.

Before that, let’s understand what’s activity-based and how it differs from traditional costing systems.

What is Activity Based Costing?

Activity-based costing is an accounting methodology in which costs are allocated to activities and processes based on the resources consumed. Unlike traditional costing systems that allocate costs to a single cost driver, like labor hours or machine usage, ABC is more detailed and considers indirect costs. It assigns costs to activities that drive the cost. Since all products do not use the same amount of resources and the overhead costs vary, ABC calculates the costs more accurately than traditional costing systems.

For example, in the steel plant’s study, the researchers realized that the ABC approach gave them more accurate data on the cost per unit volume for each raw material handled. These insights enabled them to devise strategies to reduce costs for each raw material.

Let’s find out the other ways companies can benefit from adopting it.

Activity based costing benefits

Five Reasons Why Every Company Must Adopt Activity-Based Costing

Here are five reasons why companies must adopt activity-based costing.

1.Identify misleading cost allocation

Every company wants to reduce costs and improve profitability. One way to do that is by identifying and eliminating non-value-added activities or re-allocating costs to activities that significantly add value to the business. Activity-based costing can also help calculate each product’s actual cost and empower companies to make informed pricing decisions.

Let’s look at Garware Nylons as a use case. The company manufactures polyester and nylon products. One product required steam and compressed air, while the other didn’t. The traditional costing system allocated the total cost of steam and compressed air proportionately to the turnover of both products. This increased the product’s price and impacted sales.

ABC could have solved this problem by focusing only on activities that drive costs. It would have helped Garware Nylons get a more accurate overview of each product’s cost and make informed pricing and resource allocation decisions.

2. Identify cost drivers and improve decision-making

ABC can help large service providers like Indian Railways, which has limited visibility on costs, identify cost drivers and make better decisions by providing insights on resource utilization and cost allocation.

ABC provides accurate, real-time cost-allocation data for each activity. It helps the company identify activities that drive costs and link expenses to them to understand how they contribute to overall costs.

The detailed breakdown of costs for each activity empowers companies to make informed decisions, such as streamlining operations, reducing unnecessary expenses, and reallocating resources to value-adding activities. It helps the company to optimize costs and align with long-term objectives. AirAsia’s Indian division, for instance, decided to discontinue non-profitable routes in 2014 based on the insights received through activity-based planning.

3. Tailor services and pricing strategies

When setting prices for their products or services, companies need to balance profitability and competition. The ABC approach gives companies accurate insights into product costs, sets the right price, and creates product differentiation.

Let’s take Indian banks as an example. Indian banks use traditional costing systems and primarily focus on financial accounting. It does not consider the costs allocated to different banking products and services.

However, they can use ABC to measure the costs and performance of different banking activities, products, and services. This approach will help them allocate resource costs to products, services, and customer segments based on their activities.

With accurate cost information, banks can develop competitive pricing strategies, tailor their services for the most and least profitable customer segments, and gather accurate data on the actual cost of delivering various banking services to customers.

4.Empower CFOs to make strategic decisions

A CFO’s goal is to improve the company’s bottom line. ABC helps them achieve this objective by allocating product costs based on activities and resources consumed. ABC provides a detailed breakdown of the costs associated with each activity, enabling the CFOs to make better strategic decisions. It helps them make informed decisions on product pricing and identify opportunities to improve profitability. They can also use it to re-engineer business processes and achieve operational excellence.

5. Overall advantages of activity based costing for all industries

ABC benefits all industries that want more visibility on cost allocation and improve their costing, performance, and operations.

• The Indian aviation industry, for instance, can use it to calculate crew costs, budget the cost per flight hour, streamline airplane and passenger expenses, control costs, and monitor and allocate resources depending on supply and demand.
• Small-medium enterprises can use it to identify unprofitable products and services, reallocate resources to revenue-generating business areas, improve cost-control measures, and implement competitive pricing strategies.
• Service industries like railways, banks, and healthcare can use it to price products accurately and increase profit margins.

Advantages of activity based costing

• Trace indirect costs

  • Using the ABC model, companies can attribute indirect costs like depreciation or utilities to certain activities. This helps to quantify the costs, in relation to each service or product.  This make ABC more realistic and helps companies understand what drives costs and how to improve their operations.

• Better pricing

ABC helps companies improve their pricing strategies by providing a more accurate picture of the costs involved in manufacturing a product or offering a service. This can help companies increase their profit margins.

• Identify areas for improvement

ABC helps companies identify areas where costs may be too high due to inefficiencies. Cutting out activities and inefficient processes that don’t add value helps to save money. It also helps companies to rethink business strategy and enhance operations or discontinue un profitable products.

• Better resource allocation

ABC helps companies make informed decisions about which activities to spend on, automate, and focus on. It Pinpoint Unprofitable Products. It helps companies raise the price or drop some activities or cost drivers.

• More fact-based budgeting

ABC makes the link between overhead costs and products and services more direct, making budgeting more fact-based.

How Can Companies Implement Activity Based Costing?

The ABC approach has benefited companies like Tata Consultancy Services (TCS), Castor India, and Bharat Forge. Your company can also benefit from it. Adopting ABC can help improve profit margins, optimize pricing strategies, reduce operational expenses, and make data-driven strategy decisions. It enables you to find hidden costs that eat away your profits and find cost-effective ways to deliver valuable products and services to customers.

Implementing activity-based costing can be challenging as it’s more detailed and complex than traditional costing systems. You could face difficulties due to limited resources, product range, and budget.

However, a trustworthy consultant can help you overcome these challenges.

At Pro-active Solutech, we provide cost management consulting services to companies that want to optimize costs and improve profits. We combine consulting, technologies, and training services to provide a holistic approach to cost management.

From identifying, suggesting, and executing solutions to increase profits to building cost models and implementing performance measures to optimize costs for various activities, we tailor our solutions to help you achieve your business goals.

Contact us to learn how we can help you adopt activity-based consulting in your company.