Activity Based Cost

from the Perspective of Competitive Advantage

Edwin B. Dean


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Activity based cost (ABC) is a tool for cost management. Activity based management seeks to portray a company as a series of activities which are related to customer desires and cost. Activity based cost is a process for measuring the cost of the activities of an organization. Activities within an organization are identified and an average cost is associated with each activity. The total cost of a product is the sum of the costs of activities required to bring forth, sustain, and retire the product. The cost of an activity for a product is defined as the average cost of the activity times the number of times the activity is required for that product.

Turney (1989) notes that

Underlying ABC is the assumption that activities consume resources and products consume activities. Activities include establishing vendor relations, purchasing, receiving, disbursing, setting up a machine, running the machine, reorganizing the production flow, redesigning the product, and taking a customer order. The performance of these activities triggers the consumption of resources that are recorded as costs in accounts. The activities are performed in response to the need to design, produce, market, and distribute products.

Although accountants treat the average cost of an activity as a deterministic quantity, we know from statistical process control that activity costs and duration vary in a statistical manner. This, together with the precision to which we can allocate cost to an activity, gives rise to accounting noise. This indicates that cost, even as measured by activity based costing methods, is in reality stochastic in nature. This leads into the subject of cost risk often applied within parametric cost analysis, but ignored in accounting.

Appropriately applied, ABC provides a far more accurate portrayal of cost than previous accounting methods. Given a better understanding of cost, management can make far better decisions in terms of competitive advantage. Furthermore, the improved understanding and localization of cost can be used to eliminate low value high cost activites and hence reduce cost. It is thus an aid to business process reengineering.

Cooper and Kaplan (1992) show how activity-based costing permits the very important distinction between resource usage and resource spending. The difference is unused capacity. Elimination of this unused capacity permits costs to be reduced. Unfortunately, they fail to note the necessity to take into account the statistical variation within the system which can lead to the inability to supply near peak demands and the necessity to ensure that associated downsizing does not reduce either product or enterprise quality. Failure to meet demand and reduction in product quality can lead to revenue reductions which can generate a net loss in profit over the future. Reduction in enterprise quality can increase the average cost of a number of activities to the point that the net cost reduction is negative. Cost and quality are tightly linked within the dynamic stochastic nature of the business system.

Turney (1992) illuminates important nontemporal links between cost and enterprise quality. He also illustrates important relations between resources, resource drivers, activities, activity drivers, processes, enterprise performance (enterprise quality characteristics), cost drivers, and cost. He also notes that

Cost and nonfinancial information join forces to provide a total view of the work done ....

This is the core concept upon which parametric cost analysis and theoretical cost analysis have been based since at least the early 1960s.

If you still aren't convinced activity based cost is the way to go, read Cooper and Kaplan (1988). If you are convinced, O'Guin (1991) and Innes, Mitchell, and Yoshikawa (1994) provide practical guidance. Cokins, Stratton, and Helbling (1993) is must reading for both managers and implementors.

Activity based cost is a special form of function cost analysis where the cost of the functions of the system to bring forth, sustain, and retire the product are measured, as opposed to the functions of the product measured in value engineering.

Because ABC measures the cost of implementing the functions of the system to genopersist the product, it is a direct measure of the work of human endeavor. In the Cost Primer for COSTLESS, I have used this concept to derive a generic top level activity-based structure for examining the cost of NASA operations.

ABC is a form of parametric cost analysis where cost is parameterized by average activity costs and driven by the variables which quantify the number of times an activity is used within the system to bring forth, sustain, or retire a product. A meta-activity is a bundle of activites, each with its own cost driver. The cost of a meta activity is, thus, represented by a linear equation in terms of the cost drivers. Thus, meta-activity cost, along with each activity cost, is represented by a mathematical equation within the scope of parametric cost analysis. This extendability demonstrates clearly that ABC is a viable cost estimating technology, as well as a superior accounting technology.

ABC can also be used as the measurement tool for transaction cost economics by defining the activities to be those providing the desired transactions as outputs and using the number of transactions as the cost driver. Note that activities and transactions form the nodes and links of a network with activity cost and number of transactions being the associated measures. This observation links cost to graph theory and network topology.

If the activity data base also includes quality characteristics of the product and the the system to genopersist the product, ABC can be extended to parametric accounting (Dean, 1989c) or cost deployment or parametric cost deployment (Dean, 1995b). Yoshikawa, Innes, and Mitchell (1990) provide an example of parametric accounting in the cost tables used in Japan to reduce cost during design and production. LeBlanc, (1976) provides an excellent example of parametric activity based cost where the time required for each activity is an equation defined in terms of product or process parameters. The cost is found by multiplying the time by the labor rate for the activity. Note that the date of this document precedes the existence of activiting based cost within the accounting community by a number of years.

The definition of accounting supplied by Zlatkovich, et. al. (1966) is

the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.

This definition leaves plenty of room for the application of mathematical techniques within accounting. However, the practice of accounting limits itself to numbers, as opposed to equations and coordinate systems. It only took the application of mathematics, coupled with the scientific experiment, to transform physics from an anecdotal practice into a science.

From a mathematical perspective, we can consider the activity costs to form a coordinate system which describes the means which the enterprise uses to bring forth, sustain, or retire a product. There are also other perspectives of value to management. Following Kaplan (1988) we suggest that one cost perspective is not enough. For example, we place constraints on the organization to ensure timeliness compliance, cost compliance, and quality compliance for the customer. How much do those constraints cost? This triple of compliance costs is a very useful coordinate system. Yoshikawa, Innes, and Mitchell (1994) use function analysis to develop a transformation from an activity coordinate system to the coordinate system associated with this compliance triple. Another common coordinate system is that which defines the cost of each part within a product. The mappings performed to obtain part cost or function cost from the activities consumed by the part or function are common, but unidentified, coordinate transformations.

The existence of these coordinate systems and transformations between them suggests that the mathematical concept of coordinates could play as big a role in the future of cost as it has played in the development of physics (Beyerly, 1916). Mattessich (1977) defined accounting in terms of equations. Although his ideas seem to have been spurned by the accounting community, he is a forerunner in this regard, as have been all who have practiced parametric cost analysis. Both have used equations to describe accounting, the variables of which form coordinate systems. Dean (1990a) applied the concept of coordinates to solve a cost problem using differential geometry.

Based upon the above linkages between cost and mathematics, I submit that now is time to transform cost from an anectdotal practice into a science. I am convinced that this can be accomplished if we introduce the concept of the cost experiment (Dean, 1989c) within an extension of the mathematical framework identified above. Embedding activity based cost and transaction cost economics within parametric cost analysis provides a basic framework for extending our understanding of cost. The major inhibitors to attaining a cost science are mindset and lack of mathematical and scientific training within the cost related disciplines.




Guest Contribution

An Annotated Activity Based Cost Bibliography



Activity Based Cost Bibliography


Professional Societies

Institute of Management Accountants


Surfing the Web

An Ontology for Activity-Based Cost Management
Implementing Activity Based Costing


Table of Contents | Cost Technologies | Use


Originated on 940731 | Improved on 961109
Author Ed Dean | Curator Paul Scarbrough