Activity-based and time-driven costing

Define the cost question before choosing the method

A cost object is whatever management wants to understand: a product, service, customer, project or distribution channel. The cost assigned to it depends on the purpose and boundary of the analysis. A manufacturing cost, a full relationship cost and the additional cash needed for one decision are different answers.

Direct costs can be traced to the chosen object on a practical, supportable basis. Indirect costs are shared and require further analysis. A cost can be direct to a department but indirect to its products. Calling it indirect does not mean it is unimportant or automatically fixed.

Activity-based costing (ABC) follows the resources consumed by activities and then the demands cost objects place on those activities. It can reveal differences that a single output-based allocation obscures. It does not make every estimate exact or turn an allocated cost into an avoidable payment.

Concept sources: ACCA, Activity-based costing — the limits of a single absorption base and the use of activity pools and drivers.

Recognise the level at which an activity occurs

Some support work responds to production volume; other work responds to variety or frequency. Producing twice as many units in one batch does not necessarily require twice as many machine changeovers. The cost hierarchy helps identify these differences.

A resource driver helps assign shared resources to activities, such as documented staff time. An activity driver helps assign an activity's costs to products, such as changeover hours. A transaction count works only when the transactions impose reasonably similar demands. If changeovers vary substantially, hours or separate categories may be more useful than a simple count.

Grouping unrelated work in one pool can hide the very complexity ABC is meant to reveal. Conversely, hundreds of tiny pools may create more maintenance effort than useful insight. Choose detail in proportion to the decision.

Concept sources: SMA study guide, Module 6, printed pages 305–309 — activity analysis, drivers and the cost hierarchy.

Establish one consistent original case

The fictional Riverton Display Works makes standard and adjustable display stands. Its annual production plan contains the following assumptions. The figures and circumstances are original illustrations.

The manufacturing activities to be assigned total $144,000: machine operations $72,000, equipment preparation $48,000 and design support $24,000. A further $12,000 common facility cost is disclosed separately under both methods. It has no convincing product-specific driver in this simplified management analysis.

Keeping that boundary identical makes the comparison fair. The product figures below are costs before the separately reported common facility amount, not a claim that the business can ignore that amount. All the assumed costs still need funding from the overall business.

Compare one absorption base with activity rates

Under a single machine-hour approach, the assigned overhead rate is $144,000 ÷ 3,600 = $40 per machine hour. Standard stands receive $96,000 and adjustable stands $48,000. Dividing by their respective quantities gives overhead of $40 and $80 per stand, producing costs before common facility costs of $88 and $170.

ABC retains the same $144,000 total but recognises three demands:

Activity rate = pool cost ÷ matching driver quantity. Multiply that rate by each product's use of the same driver. Do not divide one pool by a convenient but unrelated number, or mix monthly costs with annual activity.

The preparation count is assumed to represent comparable preparation effort here. The design-support hours identify work attributable to each design; they are not a second charge for the direct production labour already included in unit costs.

Allocate and reconcile before interpreting

Standard stands use two-thirds of machine time but only one-fifth of the preparations and design-support hours. The single rate therefore assigns them more of those support costs than their recorded activity use suggests. Adjustable stands account for relatively little volume but substantial support work.

The shift is $33,600: standard costs fall by $14 × 2,400, while adjustable costs rise by $56 × 600. No expenditure disappears. Under either method, direct costs of $169,200 plus assigned overhead of $144,000 equal $313,200. Adding the common facility cost gives $325,200.

Check both pool totals and product totals. A reconciliation can expose missing products, duplicated activity records or costs counted in both direct labour and an overhead pool. It does not prove that the chosen drivers reflect resource demands correctly.

Use the finding to investigate a decision

Riverton should examine whether adjustable stands justify their support demands through price, customer value or strategic role. Possible responses include simplifying designs, improving preparation methods, combining compatible production runs or changing the service offered. Larger batches can reduce preparations but increase inventory and delay; the trade-off needs evaluation.

The $226 figure is not automatically the minimum acceptable price for an additional stand. A short-term decision needs the future cash flows and opportunities changed by that order. Existing support salaries may remain unchanged, while special materials, overtime or displaced profitable work may matter. Over a longer horizon, sustained demand may require more support capacity.

Nor should a product disappear merely because an allocation makes it look unattractive. Consider effects on other sales and whether resources can actually be removed or redeployed. ABC supplies evidence about demand for resources; activity-based management uses that evidence to change activities and choices.

Concept sources: ACCA, Activity-based management — using activity information and recognising that reduced activity does not necessarily remove fixed expenditure.

Calculate a practical capacity rate for time-driven costing

Time-driven ABC (TDABC) estimates the cost of supplying a unit of resource capacity and the capacity required by a transaction. Time is often the useful unit. Resource groups with different costs or capabilities may require separate rates.

In a separate monthly illustration, Riverton's artwork-administration team costs $18,000. These departmental figures are not added to the earlier manufacturing example. Four employees each have 20 scheduled days of 7.5 hours: 4 × 20 × 7.5 × 60 = 36,000 minutes of theoretical capacity.

Allow 6,000 minutes for necessary breaks, training, meetings and other time unavailable to process the defined jobs. Practical capacity is therefore 30,000 minutes. The allowance is an explicit case estimate, not a universal percentage or an assertion that training lacks value.

Capacity cost rate = $18,000 ÷ 30,000 = $0.60 per practical minute. Using the available practical capacity keeps the rate from automatically rising merely because demand is temporarily low.

Concept sources: Harvard Business School, Robert Kaplan, Rethinking Activity-Based Costing — the Kaplan–Anderson approach uses capacity cost and transaction time, with unused capacity separately identifiable.

Build a time equation that includes complexity once

Assume a routine artwork job needs six minutes. A requested revision adds four minutes; an expedited coordination requirement adds three. Using indicators equal to one when the feature applies and zero otherwise:

Minutes per job = 6 + 4 × revision indicator + 3 × expedited indicator.

A job with both features takes 13 minutes, not seven. The additional times supplement the baseline rather than replace it. Both features can occur together because they describe separate work; verify that the measured increments do not overlap before adding them.

The month contains 2,400 jobs. Of these, 600 require revision and 200 expedited coordination, including 50 that require both.

An independent check is 2,400 × 6 + 600 × 4 + 200 × 3 = 17,400 minutes. Every job receives baseline time once. Only qualifying jobs receive each addition.

Validate times through observation and staff knowledge. Extremely different tasks may need separate equations, while unusual exceptions need investigation rather than being forced into an inappropriate average.

Keep unused capacity visible

Unused capacity is 30,000 − 17,400 = 12,600 minutes, costing $7,560 at the capacity rate. Thus $10,440 used capacity + $7,560 unused capacity = $18,000 supplied capacity cost. Utilisation is 58% of practical capacity.

The 6,000-minute allowance between theoretical and practical capacity is not this unused capacity. It was already removed in estimating the capacity available for the defined work. Confusing these amounts would distort the rate and the reported opportunity.

Unused capacity does not automatically mean waste or an immediate saving. It may support demand peaks, resilience or expected growth. Examine whether it is available at the times and in the skills needed. If it persists, management can consider additional work, redeployment or a justified change in resources supplied. Cash savings require a real reduction in future payments; allocating fewer dollars to jobs is insufficient.

Concept sources: SMA study guide, printed pages 316–322 — practical capacity, time equations and the distinction between used and unused capacity.

Maintain the model and check the reasoning

Review the model when resource prices, processes, capacity or transaction mix change. Reconcile it with spending records; document estimates and review uncertain drivers. Employee interviews and transaction data can both contain error. A detailed model with stale inputs is not more reliable merely because it has more decimal places.

ABC is especially worth investigating when important overheads support products or customers with different complexity. A simpler approach may be adequate where demands are similar and the extra information would not alter a worthwhile decision. Service organisations can use the same logic, defining activities and cost objects suited to their work.

Self-check: An analyst assigns six minutes to routine jobs and only four minutes to revision-only jobs. They also describe all 18,600 minutes between theoretical capacity and estimated job time as unused capacity. What needs correction?

Answer: Revision-only work takes 6 + 4 = 10 minutes. Unused capacity is measured against practical capacity: 30,000 − 17,400 = 12,600 minutes. The separate 6,000-minute allowance is not available processing capacity. Correct both calculations before suggesting savings or staffing changes.

Sources and further reading

Study-guide reference: Module 6 > Strategic product costing, ABC and TDABC > Pages 303–322. Riverton and all figures are original illustrations.

• ACCA, Activity-based costing — activity rates and absorption comparisons.
• ACCA, Activity-based management — decisions and cost-behaviour cautions.
• Harvard Business School, Rethinking Activity-Based Costing — time-driven capacity analysis.