Development of Activity Based Costing

Posted on December 13th, 2009 in Finance by

Development of Activity Based Costing

Often times when ideas and techniques become commonplace in our everyday lives and in our professional lives we lose sight of where these ideas originated. With more and more businesses switching to activity based costing maybe some thought should go into considering how this method came to be and why it has continued to grow. Activity based costing, or more commonly ABC, is a method for determining accurate costs. It assigns resource costs to cost objects based on activities performed for the cost objects. Costs of resources are assigned to activities based on their use of those resources, and costs of activities are assigned to only to cost objects that are actu

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ally demanding the activity.

Robert Kaplan and William Bruns, both Harvard Business School professors, first fully explained the subject in a chapter of their 1987 book Accounting and Management: A Field Study Perspective. They presented activity based costing as a way to solve the problems of traditional costing systems, which were unable to determine the actual costs of production accurately. Their original focus was on the manufacturing industry where new technology and improvements had reduced the proportion of direct labor and material costs but increased the proportion of indirect costs (Weiner). They knew a new system needed to be developed.

Most accountants agree that activity based costing came onto the scene in the mid-1980s. Prior to that, the United States had dominated the world’s economy after World War II. During the period from the 1950s to the 1970s, the focus of American companies, in order to achieve growth and profitability, was only on output and not quality or cost control. They only needed to produce the product and get it out on the market quickly to make a profit. That was until the 1980s when Japanese began to produce low cost, high quality goods. Their secret was not a highly developed costing system, but simply producing a small number of high quality products. United States companies needed a way to reduce costs and increase quality in order compete with these foreign markets. That is when managers began to employ activity based costing, which would help identify cost-reduction opportunities (Weil, Maher 218). By 1992, activity based costing had gained worldwide recognition and was being used in America, Europe, Asia, and Australia (Cooper, Kaplan, Maisel, Morrissey, Oehm 27).

Although Kaplan, Bruns and another of Kaplan’s partners, H. Thomas Johnson brought to light the workings and benefits of activity based costing in modern accounting, they were not the first to suggest the abandoning of traditional costing methods. The man responsible for the original suggestion of activity based costing methods was Alexander Hamilton Church. Church began writing on the subject of overhead in 1901. Overhead, Church claimed, was the cost of several factors of production and each should be traced individually to the products. He believed that information about a product’s cost should show all the resources used to make the product (Johnson, Kaplan 54). His little shop analogy, where each production center was treated as a separate factory, illustrated how a firm should charge these individual production centers for each of the many types of manufacturing overhead (Weil, Maher 737). Church felt that accountants of the time needed to realize that manufacturing resulted in many cost drivers (Weil, Maher 737). Though there may have been others before him, his ideas of allocating overhead in ways other than just direct labor were the some of most influential.

Recently activity based costing has grown in popularity due to four specific factors. One reason is the significant increase in manufacturing overhead cost. Another is that manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours. Still another reason for the growth of activity based costing is the increased diversity of products produced by a company and the diversity of customer demands. Finally, within a company, some products are being produced in large batches while others are only in small batches (Activity Based Costing). While this method tends to be more complicated, because of its accuracy, the procedure of activity based costing will most likely continue to grow in use for years to come and it is all due to the work of these scholars.

Works Cited

“Activity Based Costing.” AccountingCoach.com. 13 April 2008.
Cooper, Robin, Robert S. Kaplan, Lawrence S. Maisel, Eileen Morrissey, and Ronald M. Oehm. Implementing Activity-Based Cost Management: Moving from Analysis to Action. Montvale, NJ: Institute of Management Accountants, 1992.
Johnson, Thomas H., and Robert S. Kaplan. Relevance Lost: The Rise and Fall of Management Accounting. Boston: Harvard Business School Press, 1987.
Weil, Roman L., and Michael W. Maher. Handbook of Cost Management. Hoboken, NJ: John Wiley & Sons, Inc., 2005.
Weiner, Jerry. “Activity based costing for financial institutions.” Journal of Bank Cost & Management Accounting, 1995.

Development of Activity Based Costing / Victoria K. Lightcap