Activity based costing and management - ABM for process rede...

Learning Outcomes

By studying this article, you will understand how activity based costing (ABC) identifies cost drivers and allocates overheads, and how activity based management (ABM) builds on ABC to drive operational and strategic improvements. You will be able to explain the relevant steps, apply ABM to process redesign, and evaluate the performance impact. You’ll also recognize practical considerations and common exam pitfalls.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand activity based techniques as tools for performance improvement. In particular, you should focus your revision on:

• The principles and steps of activity based costing (ABC) for assigning overheads to cost objects
• The distinction between ABC and traditional costing systems
• The concept and application of activity based management (ABM)
• The use of ABM to identify value-adding and non-value-adding activities in process redesign
• How ABM information facilitates operational and strategic decisions to improve efficiency and effectiveness
• The benefits and limitations of ABC and ABM for process improvement
• Evaluating the impact of ABC/ABM implementation on performance reporting and organisational culture

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary purpose of identifying cost drivers in activity based costing?
   1. To allocate direct materials
   2. To assign overheads based on actual consumption of activities
   3. To group costs by department
   4. To calculate direct labour hours required
2. Which of the following best describes a non-value-adding activity discovered through ABM?
   1. Final product assembly for customers
   2. Multiple inspections of completed units due to rework
   3. Customer order delivery
   4. Regular preventive maintenance

3. True or false? ABM can be used both to reduce waste and to support strategic decisions such as product rationalization.

4. Give two potential limitations of implementing ABC or ABM in a service organisation.

5. List the steps required to implement activity based costing in a manufacturing business.

Introduction

Organisations increasingly need accurate cost information to remain competitive. Traditional absorption costing systems, often based solely on volume measures such as direct labour hours, can distort product costs in modern businesses with diverse offerings and significant overheads. Activity based costing (ABC) provides a more precise method for tracing costs to products or services by focusing on activities and their drivers.

Building on ABC, activity based management (ABM) uses these findings to inform decision-making and drive process redesign. ABM identifies both value-adding and non-value-adding activities, supporting management in improving operational efficiency and aligning resources with organisational strategy.

This article covers the fundamentals of ABC, the framework for ABM, and how these approaches can be applied in practice to design processes that boost performance.

Key Term: activity based costing (ABC)
A method of assigning overheads to products or services based on the activities required to produce them, using cost drivers that reflect actual resource usage.

Key Term: activity based management (ABM)
The use of activity based costing information to manage activities for continuous improvement, cost reduction, and performance enhancement.

Key Term: cost driver
A factor that influences or causes the cost of an activity to increase or decrease.

Activity Based Costing: Principles and Process

Activity based costing (ABC) aims to allocate overheads more accurately by focusing on activities performed and their respective resource consumption. This is particularly useful in complex environments where products, services, or customers consume overhead resources in differing proportions.

ABC typically follows these steps:

1. Identify and analyse key activities performed by the organisation.
2. Assign costs to activity cost pools.
3. Determine appropriate cost drivers for each pool.
4. Calculate a cost rate for each driver.
5. Assign activity costs to products or services based on their usage of each activity.

ABC is especially valuable for identifying cost distortions and supporting more accurate pricing, product mix, and discontinuation decisions.

Worked Example 1.1

A manufacturer produces three products: Basic, Plus, and Premium. It identifies setup costs, materials handling, and quality inspections as major overheads. The setup activity is driven by the number of production runs. During the year, Premium required 30 setups, Plus 10, and Basic 10. Setup cost pool is £60,000.

How much setup cost should be allocated to Premium?

Answer:
Total setups = 30 (Premium) + 10 (Plus) + 10 (Basic) = 50 setups.
Setup cost per setup = £60,000 / 50 = £1,200.
Premium's allocation = 30 setups × £1,200 = £36,000.

Activity Based Management for Process Redesign

Activity based management (ABM) extends beyond costing, leveraging ABC data for process improvement and strategic decision-making. ABM uses activity analysis to distinguish:

• Value-adding activities (required to meet customer expectations)
• Non-value-adding activities (do not increase value from the customer’s viewpoint, such as rework, movement, or waiting)

By mapping all activities within a process, ABM helps managers identify waste and restructure processes for greater efficiency, quality, or speed.

Key Term: value-adding activity
An activity that contributes directly to meeting customer needs or business objectives and for which customers are willing to pay.

Key Term: non-value-adding activity
An activity that does not contribute to customer value or is unnecessary from a process viewpoint (e.g., rework, waiting, redundant checks).

Worked Example 1.2

ABM analysis reveals that a company’s customer-order process includes three approval stages, repeated document reviews, and several handovers. Time and cost data show that approvals and duplicate reviews account for 45% of the process cost.

How could ABM help improve this process?

Answer:
ABM highlights non-value-adding activities such as multiple approvals and repeated reviews. Management could redesign the process to eliminate unnecessary approvals, reduce duplication, and enable staff, leading to lower cost, faster turnaround, and improved customer satisfaction.

Linking ABC/ABM to Performance Improvement

ABM supports both operational and strategic performance enhancement:

• Operational: Streamlining processes by reducing or eliminating non-value-adding activities, lowering costs, and improving quality.
• Strategic: Informed decisions about product/service rationalisation, resource allocation, customer profitability, and market focus.

Successful ABM initiatives support continuous improvement and can be integrated with other management approaches such as total quality management (TQM), lean production, or process reengineering.

Worked Example 1.3

A service firm uses ABC to allocate HR, IT support, and premises costs. Analysis shows that serving Small Clients costs the firm more per £ earned than serving Large Clients due to high setup and support activities. ABM suggests reviewing pricing, minimum contract size, or service offerings for Small Clients.

What strategic benefits does this offer?

Answer:
The firm can improve overall profitability by either modifying its service to Small Clients, increasing prices, or focusing on more profitable client segments. ABM provides understanding to support such realignment.

Exam Warning

In the APM exam, be ready to critically assess ABC/ABM systems for practicality. Many organisations lack the detailed data collection systems required, and maintaining ABC may become too costly or complex. Always discuss not only benefits but also implementation challenges.

Benefits and Limitations of ABC/ABM

Benefits:

• More accurate cost allocation
• Informs pricing, mix, and process redesign decisions
• Supports identification of waste and improvement targets
• Improves understanding of what drives costs

Limitations:

• Can be costly and time-consuming to implement and maintain
• Difficult to select correct cost drivers or accurately trace resources in service environments
• Data collection may be resisted by staff
• Not all overheads are easily attributable to activities
• Complexity may outweigh benefits in organisations with simple processes or where overheads are minimal

Revision Tip

For APM exam questions on ABM, state how eliminating non-value-adding activities can improve both cost efficiency and customer experience. Use specific examples from the scenario.

Summary

ABC gives a more precise view of cost structures, especially where products, customers, or services consume resources in varied ways. ABM uses this knowledge to drive out waste, improve processes, and support better decision making. However, practicality and cost of implementation must always be assessed before recommending ABC/ABM in exam answers.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain activity based costing and identify appropriate cost drivers for key activities
• Outline the steps involved in implementing ABC in an organisation
• Distinguish between value-adding and non-value-adding activities using ABM
• Illustrate how ABM informs process redesign to reduce waste and improve performance
• Discuss operational and strategic uses of ABM for resource reallocation and decision support
• Evaluate the benefits and limitations of ABC/ABM, including practical implementation factors

Key Terms and Concepts

• activity based costing (ABC)
• activity based management (ABM)
• cost driver
• value-adding activity
• non-value-adding activity