The selection of the right cost calculation method is of critical importance when it comes to determining the real product profitability (as well as clients and other calculation objects). Traditional cost calculation methods often provide false information. The literature offers many examples of big companies that have given up traditional methods and applied a new method: activity-based costing (ABC). They discovered that many products that are manufactured generate losses and not profits. Managers, based on incorrect calculations, mistakenly believed in the profitability of each product. Turney (1991) reports on an example of an American manufacturer of over 4,000 different integrated circuits. The cost calculation with the allocation of direct production costs as machinery-hour markup demonstrated a profit margin of over 26% for each product. Implementing ABC showed that the production of more than half of the products was not profitable, and having factored in additional sales and management costs (which accounted for about 40% of the total costs), it was as much as over 75%.
Key Terms in this Chapter
ABC System: “A system that maintains financial and operating data on an organization’s resources, activities, drivers, objects and measures. ABC models are created and maintained within this system.”
Process: “A series of time-based activities that are linked to complete a specific output.”
Profitability Analysis: “The analysis of profit derived from cost objects with the view to improve or optimize profitability. Multiple views may be analyzed, such as market segment, customer, distribution channel, product families, products, technologies, platforms, regions, manufacturing capacity, etc.”
Resources Economic: “Elements applied or used in the performance of activities or to directly support cost object. They include people, materials, supplies, equipment, technologies and facilities.”
Cost Object: “Any product, service, customer, contract, project, process or other work unit for which a separate cost measurement is desired.”
Activity-Based Costing (ABC): “A methodology that measures the cost and performances of cost objects, activities and resources. Cost objects consume activities and activities consume resources. Resources costs are assigned to activities based on their use of those resources, and activity costs are reassigned to cost objects (outputs) based on the cost objects’ proportional use of those activities. Activity-Based costing incorporates causal relationships between cost objects and activities and between activities and resources.”
Activity-Based Information System (ABIS): An ABC system supported by information technologies. It is an information system that includes the ABC model. ABIS can by supplied by data from transactional systems, data warehouses, and other data sources. Data that are specific for ABC can be manually entered into the ABIS database. Mainly, specialized ABC modeling and reporting tools (e.g., online analytical processing or business intelligence tools) are used in ABIS.
Resource Driver: “The best single quantitative measure of the frequency and intensity of the demand placed on a resource by other resources, activities, or cost objects. It is used to assign resource costs to activities, and cost objects, or to other resources.”
Activity Work: “Performed by people, equipment, technologies or facilities. Activities are usually described by the ‘action-verb-adjective-noun’ grammar convention. Activities may occur in a linked sequence and activity-to-activity assignments may exist.”
Activity Driver: “The best single quantitative measure of the frequency and intensity of the demand placed on an activity by cost objects or other activity. It is used to assign activity costs to cost objects or to other activities.”