Activity Based Costing in ERP

Activity Based Costing, hereinafter referred to as ABC, is a new management method for period cost allocation proposed by R. Cooper and R.S. Kaplan in the end of the eighties. With respect to the issue of period cost allocation, the ABC method is widely applied in large ERP software overseas, which is quite different from traditional period cost allocation. Based on traditional period cost allocation, the total period cost is allocated to various work centers simply according to labor or machine time to calculate the period cost of products.

Activity-Based Costing provides a process-oriented, cross-functional view of overhead, in contrast to the traditional location-oriented view provided by Cost Center Accounting. Activity-Based Costing thus complements and enhances Cost Center Accounting.

Activity-Based Costing allocates process quantities based on resource and process drivers, allowing you to define cost allocation along the value-added chain more exactly than is possible with overhead rates. Activity-Based Costing also complements and enhances product costing by assigning costs to the business processes where they originated. Cost center resources can allocate to business processes based on their true utilization of activities.

Implementing Activity Based Costing

All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client’s needs and circumstances.

But what about cost allocation’s other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)?

Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability. By knowing what the true “cause-and-effect” relationship is, managers are able to more accurately assess the true cost of a product or service and determine if carrying certain products and/or services contributes to overall profitability given the demand for and price these products/services sell for. This is especially important as it pertains to both operational decisions (such as calculating the maximum price a firm can charge, especially for a “commodity” product, determining the maximum cost a firm is willing to pay to provide this product or service, and in making special order and transfer pricing decisions) and capital/long-term decisions (such as make-or-buy component decisions, continue or discontinue a product line decisions, process further decisions, etc,).

Cost allocation can also be used to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E) by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. It can also be used to manage product and process design. As allocations are broken down/determined, the use of resources becomes transparent from a process standpoint, allowing managers to improve operations as needed.