In this section of the report, we shall discuss the interlinked processes of Activity Based Costing, Activity Based Budgeting and Activity Based Management by using the help of certain diagrams and also touch upon the evolution of the Activity Based approach over time.
The diagram shown above explains how costs are assigned to a product under the ABC approach. ABC first assigns costs to the activities that are the real cause of the overhead and then assigns the cost of those activities only to the products that are actually demanding the activities.
ABC allocates overheads in a two-stage process. The first stage allocates overhead costs to activity cost pool (Cost Pool A, B or C as shown above). Activity cost pool is the overhead cost attributed to a distinct type of activity. Example of overhead cost pools are ordering materials, setting up machines, assembling products, inspecting products. The second stage assigns the overhead allocated to the activity cost pools to the products (Product A, B & C), using cost drivers for e.g. number of purchase orders, number of setups, labor hours, or number of inspections. (Jerry J. W., Paul D.K., Donald E. K. 2008). The cost drivers measure the number of individual activities undertaken to produce products or provide services. Therefore, they are helpful in order to trace indirect costs to products and in providing two roles for management accountants i.e. assigning the costs to cost objects and explaining cost behaviour.
Activity Based Budgeting is an approach to the budgeting process that focuses on identifying the costs of activities that take place in each area of a business and in determining how those activities relate to one another. The above diagram lays down the link between ABC and ABB. ABB begins with output and then determines the resources necessary to create that output. Ideally, the organization translates its vision into a strategy with definable objectives in order to create value. ABB, by focusing on the process, gives managers guidance in order to achieve the desired results. When ABB is used, the root causes can be identified, and this knowledge can be used to effect process and cost efficiencies and create value-added products and services (Hansen and Mowen, 2003).
ABB process is a reverse process of the ABC approach. The figure shows that ABB begins with the forecasted demand for goods (sales budget) and focuses on estimating the demand for each activity’s output as measured by its cost driver. Following this, it uses the rate at which activities consume resources to estimate or budget the resource needed. This approach is used to set objectives for the firm thus helping in the long term growth and stability of the business. Contrary to cost based budgeting, ABB focuses on the dynamics and coordination of the internal functioning of the organization and then allocating funds to each function based on a systematic cost analysis.
According to Kaplan (2007) Activity Based...