Activity Based Costing

Activity-Based Costing (ABC) is a technique for accumulating cost for a given cost object (i.e. product, service, customer) that represents the total and true economic resources required or consumed by the object. Activity Based Costing occurs in two phases. First, cost data is reorganized into activity cost pools. In other words, costs of significant activities are determined. This first phase is sometimes referred to as activity based process costing. Then, the amounts in the cost pools are assigned to products, services or other cost objects. The second phase is referred to as activity based object costing.

The goal of ABC is to model the causal relationships among resources, activities, and entities in assigning overhead costs. “The fundamental belief behind this costing approach is that cost is caused and causes of cost can be managed. The closer you can come to relating the costs to their causes, the more helpful your accounting information will be in guiding the management decisions of your business.” states the Ernst & Young Guide to Total Cost Management (Ernst & Young, 1992). Enterprises use resources to conduct activities. Resources perform activities to benefit products and services. The key to understanding cost dynamics in any enterprise is modeling the relationship between activities and their causes and modeling the relationship between activities and costs. If cost dynamics are not modeled (which is usually the case with traditional management accounting information systems), the performance information provided is incomplete or misleading.

The architecture of SIMPROCESS provides an integrating framework for ABC. The building blocks of SIMPROCESS are Processes, Resources, Entities (flow objects), Activities, ABC, and dynamic Process analysis. ABC embodies the concept that a business is a series of inter-related Processes, and that these Processes consist of Activities that convert inputs to outputs. The modeling approach in SIMPROCESS manifests this concept and builds on it by organizing and analyzing cost information on an Activity basis.

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Benefits of ABC with SIMPROCESS

Significant value of the ABC analysis in SIMPROCESS comes from the dynamic analysis of costs based on the event-driven simulation. Because SIMPROCESS keeps track of resource interdependencies and captures the random nature of processes, the cost statistics provided by SIMPROCESS are far more accurate than results obtained from static analysis. Benefits of ABC in SIMPROCESS include:

Focus on Cost Drivers

One of the most important benefits of ABC is the focus it provides for estimating the key causes of costs. Executives can use these estimates to prioritize and monitor improvement efforts. For example, understanding the cost of poor quality can justify the investment in a quality program. Likewise, understanding the cost of complex or diverse products and services can help streamline the product and service offerings.

Strategic Pricing

Life cycles of product and services are becoming shorter and shorter. The up-front costs of developing, testing, and marketing are not recouped until revenue is generated. Understanding the cost trade-off between life cycle stages is critical to strategically pricing the products. That is, understanding when the total investment in product development can be recouped is valuable information for strategic pricing. ABC with SIMPROCESS allows simulation of the process changes during the life cycle of a product/service for strategic or time-based pricing.

Evaluation of Capital Investments

Reengineering business processes requires a trade-off between the benefits and costs of making process improvement changes. Without the trade-off, executives and managers are faced with making large investment decisions based on gut feel. ABC with SIMPROCESS provides an analytical tool for accurate evaluation of capital investments.