Cost Leadership Strategy

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Activity Based Approaches to Cost Analysis

The examination of activities across the entire chain of value adding organizational processes underlying causes (drivers) of costs and profits  is known as activity based cost accounting - Broomwich  & Bhimani.  This introduces  the important concept that costs  are incurred in selling and distributing a product and the costs of servicing customers are possibly  now more important than production.

Activity Based Costing is therefore an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final products. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attact activity costs to outputs.  A cost driver is any factor which causes a change in the cost of an activity.

Activity based costing is most appropriate where overhead is a relatively important cost element and there is a diversity of product lines and possibly markets. Essentially, it requires pooling the overhead spend and allocating it over activities.

The mechanics of activity based cost accounting  can be split into  three stages. Stage  one is the collection of overhead costs in the same way as traditional overhead control accounts would operate. Stage  two involves the pooling of costs based upon the activities which have consumed resources rather than on the basis of production departments or centres.  Lastly, the various overhead transactions are then allocated to the products based upon a series of cost drivers which indicate how the product has made demands upon the various activities. The rates for charging out are based upon dividing the activity cost for a period by the cost driver volume. Thus the cost of the purchasing function will be divided by the number of purchase orders raised by each department.

This type of costing first appeared in the 1950s when some US firms made attempts to accurately allocate their selling and distribution overheads. In the 1970s, when zero-based budgeting came into fashion, some of the analysis was based upon activity. However, it was the work of Robin Cooper and R S Kaplan that eventually codified activity based cost accounting  into a coherent framework and disseminated it among academics, consultants and practicioners.