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Using Activity-Based Costing (ABC) to Increase Profitability

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Businesses rely on strategic and inventive accounting methods to stay profitable in competitive markets. There are a variety of cost accounting methods available to collect, analyze, and evaluate a company’s spending and investing habits, all of which inform management of how production processes can be streamlined and costs can be reduced. Of all the tools available to accountants and business managers, the activity-based costing (ABC) method is able to increase profitability by saving business time, money, and resources.

ABC Compared to Traditional Methods

Activity-based costing is an accounting method that assigns costs to products or services based on the activities and resources that make up the overhead of manufacturing a product or providing a service, whereas traditional methods allocate production costs based on specific factors, such as labor, materials, marketing and other sources of overhead. Activity-based costing is more logical and efficient for companies making customized products because overhead costs are not spread evenly across all products. For example, a low-volume product may necessitate minimum machine hours as well as multiple indirect costs and a high-volume product may require maximum machine hours with no indirect costs. If the overhead of both products is based solely on machine hours, as is usually the case with traditional costing methods, then the overhead costs of the low-volume product would not be accurate, which could result in the company suffering significant financial losses.

The Implementation Process

Implementing the ABC method requires an investment of time and resources from management as well as focus and dedication from all members of an organization. It can be a complicated and detailed task, as every business activity must be broken down to its essential components.

  • The first step is to identify the products for which costs need to be allocated. Companies may find it helpful to start with one product that is easily approachable from an ABC perspective in order to see if the method is beneficial before implementing ABC in all aspects of their business.
  • Next, companies will have to identify all of the direct costs, activities, and indirect costs associated with each activity required to manufacture a product. All aspects should be investigated, which may include negotiating with suppliers, handling complaints, issuing purchase orders, and more. Companies can hire consultants or utilize activity-based costing software to help organize information and coordinate with the existing accounting system.

Benefits that Increase Profitability

The main goal of using the activity-based costing method is to increase the profitability and overall performance of an organization. The ABC method does this by identifying accurate overhead costs and cost drivers leading to more streamlined business processes. When all direct and indirect costs are allocated to a product, managers begin to get an idea of which business processes are performing well and which are inefficient. They can then streamline these processes by allocating more resources to profitable activities and eliminating practices that are costly and wasteful. As a result of the ABC process, companies are better able to manage manufacturing performance and improve the quality of products and services. Overall, profitability is increased as a result of more accurate product pricing which can allow companies to offer competitive pricing while maximizing their returns.

Chrysler: A Case Study

In 1991, the major automobile manufacturer Chrysler introduced activity-based costing as part of their accounting practices. After overcoming internal resistance, training team members and enduring initial failures, they were able to successfully implement ABC throughout the organization. Since its implementation, Chrysler estimates that ABC has helped generate hundreds of millions of dollars for the corporation by initiating simplified product designs and eliminating redundant and unproductive activities. This represents returns that are ten to twenty times greater than the company’s investment and implementation costs of the ABC program. In addition to the financial benefits to the organization, Chrysler has become a teacher and innovator for other organizations looking to apply ABC methods into their accounting practices. They even sponsor their own five-day Core Competency Course, which has been attended by over 600 people.

It is important that organizational leaders and managers keep their operations efficient and profitable. However, implementing new accounting methods can be costly and time consuming. If managers are able to test new methods and gain the support of stakeholders and team members, activity-based costing can take their organization to the next level.

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Sources

http://www.economist.com/node/13933812

http://smallbusiness.chron.com/disadvantages-advantages-activitybased-costing-45096.html

http://www.investopedia.com/terms/a/abc.asp

https://hbr.org/1995/07/tapping-the-full-potential-of-abc

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