## **Learning Outcomes**

This article explains activity based costing (ABC) and activity based management (ABM) with a focus on process analysis and customer profitability. After studying, you will be able to describe activity identification, select suitable activity cost drivers, analyze process value, and assess customer profitability using ABC/ABM information in performance management scenarios.

## **ACCA Advanced Performance Management (APM) Syllabus**

For ACCA Advanced Performance Management (APM), you are required to understand both the technical aspects and application of process analysis and customer profitability within ABC/ABM systems. In particular, revision should focus on:

- The concept and benefits of activity based costing (ABC) and activity based management (ABM)
- Identifying and categorizing activities, and assigning appropriate cost drivers
- Applying process analysis to improve resource usage and eliminate non-value adding activities
- Performing customer profitability analysis using activity-based information
- Evaluating the limitations and practical challenges of implementing ABC and ABM

## **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 main difference between traditional absorption costing and activity based costing with respect to overhead allocation?
2. When conducting activity analysis for ABC, what criteria should be used to select appropriate cost drivers?
3. Which of the following is an example of a non-value adding activity?
   a) Assembling products
   b) Machine setup
   c) Quality testing to customer specification
   d) Direct material input
4. A customer frequently orders small quantities, induces several rush deliveries, and often returns items. According to ABC customer profitability analysis, how would this likely affect their profitability score?
5. Briefly explain one limitation that may occur when implementing ABC in a service organisation.

## **Introduction**

ABC and ABM are designed to analyze and manage costs more accurately by focusing on activities as the origin of resource consumption. ABC assigns overheads to activities, then relates those costs to products or customers via cost drivers. ABM uses this information to optimize processes and improve profitability. In process analysis, focus is placed on identifying value-adding and non-value-adding activities, improving efficiency, and supporting customer profitability assessment.

> **Key Term: activity based costing (ABC)**
> A costing method that assigns overheads to products or customers based on the activities required for their production or service, using cost drivers to reflect resource consumption.
>
> **Key Term: activity based management (ABM)**
> The use of ABC information to manage activities and processes to improve efficiency, reduce costs, and improve customer value.
>
> **Key Term: process analysis**
> A systematic examination of business activities with the aim of identifying, streamlining or eliminating non-value adding processes.

## **ABC and Process Analysis**

Activity analysis forms the basis of both ABC and ABM. Each process is broken down into discrete activities, which are grouped into cost pools.

### Identifying Activities

Activities are identified by observing and documenting process steps. Common categories include:

- Unit-level: Performed on each individual product or service unit (e.g., assembly).
- Batch-level: Related to groups of units (e.g., machinery setup).
- Product-sustaining: Support a specific product line (e.g., product design).
- Facility-sustaining: Support the business as a whole (e.g., building maintenance).

> **Key Term: cost driver**
> A factor that directly influences the cost of an activity, used in ABC to assign overhead costs to products or customers.
>
> **Key Term: non-value adding activity**
> Any process or task that consumes resources but does not increase worth from the customer’s viewpoint.

### Selecting Activity Cost Drivers

Choosing an appropriate cost driver is critical. Good drivers reflect a direct causal relationship and are practical to measure. For example, number of machine setups, purchase orders raised, or customer support calls made.

### **Worked Example 1.1**

A company incurs high costs for frequent machine setups. Management wants to include setup costs more precisely in product costs. Previously, overhead was allocated by direct labour hours.

**Question:** How should ABC allocate setup costs, and what impact does this have on product costing accuracy?

> **Answer:**
> Under ABC, setup costs form a cost pool with "number of setups" as the cost driver. Products requiring more setups would receive a larger share of the total setup cost, unlike the traditional system where the overhead allocation was unrelated to actual setups. This improves product cost accuracy, highlighting costly batches that may need process improvement or price review.

## **Activity Based Management: Improving Processes**

ABM shifts focus from cost assignment to process improvement. The goal is to reduce or eliminate non-value adding activities, streamline workflows, and reallocate resources to activities that improve customer value.

Common ABM approaches include:

- Identifying bottlenecks and root causes of cost overruns
- Redesigning or eliminating non-essential process steps
- Using benchmarks to establish process performance targets

### **Worked Example 1.2**

During process analysis, a logistics company identifies that order checking and authorisation takes longer than the actual delivery of goods.

**Question:** What ABM steps can be taken to improve efficiency, and how does this relate to cost reduction?

> **Answer:**
> ABM would recommend mapping out each process step, measuring time and resources expended, and evaluating whether all checks are necessary. Redundant approvals might be removed, electronic systems introduced, or authorisation limits raised. By streamlining, time is saved and associated overheads (e.g., staff hours, overtime) are reduced, resulting in lower costs for the same output quality.

### **Exam Warning**

In exams, look for hidden or overlooked non-value adding activities. Always suggest practical ABM measures to address them, not just theoretical improvements.

## **Customer Profitability Analysis with ABC**

ABC enables customer profitability analysis by tracing overheads to individual customers based on the specific activities they generate. This highlights high-maintenance customers who consume disproportionate resources despite modest revenues.

Common customer-specific activities include:

- Order processing
- Special packaging
- Rush deliveries
- After-sales service

A customer who requires frequent small orders, time-consuming support, urgent shipments, and frequent returns will attract a much higher share of overheads under ABC than one who orders efficiently.

### **Worked Example 1.3**

Customer X places frequent small orders, often requests urgent handling, and returns 20% of goods purchased. Customer Y orders large quantities in advance and never returns items.

**Question:** Based on ABC customer profitability analysis, how should management respond to each customer type?

> **Answer:**
> ABC will show Customer X as less profitable (possibly even loss-making) after allocating all activity costs linked to their behavior. Management should consider changing pricing, setting minimum order sizes, negotiating improved terms, or even discontinuing unprofitable customer relationships. Customer Y is more profitable and can potentially be offered incentives to increase business.

## **Limitations and Challenges of ABC/ABM**

While ABC and ABM provide better cost transparency, practical issues may arise:

- Cost drivers may be difficult or costly to measure precisely
- The complexity of tracking every activity may outweigh the benefit in simple or stable environments
- Staff may resist changes to established processes or new reporting burdens
- Service industries may struggle to identify discrete activities or find measurable drivers

### **Revision Tip**

Focus on selecting a manageable number of significant activities and cost drivers that reflect major overhead consumption, rather than attempting to track every minor activity.

## **Summary**

ABC and ABM offer more accurate methods to assign overhead and understand process costs by analyzing activities and their drivers. Process analysis identifies where activities add (or do not add) value, while customer profitability analysis ensures resource allocation supports profitable customers. The information supports informed decisions on pricing, process change, and cost management. However, implementation must be justified by likely benefits relative to costs and complexity.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define activity based costing (ABC) and activity based management (ABM)
- Identify and classify business activities and select suitable cost drivers
- Distinguish between value-adding and non-value-adding activities using process analysis
- Explain the use of ABC in customer profitability analysis, including appropriate management actions
- Evaluate the organisational and practical limitations of implementing ABC and ABM

## **Key Terms and Concepts**

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

Activity based costing and management - Process analysis and customer profitability