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Benchmark Six Sigma Expert View by Venugopal R Any organization that deals with multiple product lines or services will have activities and expenses that are highly specific to the product lines or service verticals. There would also be many activities and expenses that are considered more in general and applies across the organization. Examples of such activities that are applicable across the organization are Administration, Infrastructure, Employee welfare related, Communication and IT, Energy consumption, Dealing with regulatory bodies and so on.. The method of costing that finds ways of allocating the ‘overhead’ expenses to functions, products or services is known as Activity Based Costing (ABC). Activity Based Costing will invoke more responsibility and cost consciousness within each function. Each function knows that they are being monitored for the share of ‘common’ expenditure related to them. From a Lean Six Sigma perspective, this helps in allocating 'base line costs' and 'post-project' cost benefits more specifically. For instance, there is an efficiency improvement project taken up by a testing laboratory within a factory, and one of the components of cost saving is the energy consumption. ABC will help to track whether there is reduction in energy consumption by the testing laboratory after the project is implemented. Another example could be a project where the ‘Learning & Development’ department brings out innovative training methods and one of the benefits is to reduce need for employees to travel from distant locations to attend training programs. If the ABC allocates the portion of travel costs associated with the training to Learning & Development department, the related savings associated to their project can be quantified objectively. While the ABC has many benefits, it does pose certain challenges as well. One example is where ABC is used to allocate the costs for a "Enterprise Business Excellence Program" to every function. Sometimes, when the Business Excellence team tries to drive certain initiatives, some functions may show resistance, since they become overtly cost conscious and may not even envision the long term organizational benefit due to such initiatives. This will require good conviction building to gain acceptance. Some organizations maintain the costs for such company-wide programs as part of the "corporate cost head", so that the individual functions cannot debate on such programs in the name of their P&L getting impacted. There could be certain expenses, where it would be practically difficult to do the ABC. For example, if an organization has multiple floors, it may be difficult to allocate the expenses for running and maintaining the elevators across functions, products or services! Overall, Activity Based Costing is a very useful methodology and may be applied with prudence as per the tolerance of the organization

Advantages of ABC Analysis, For example we consider a company manufacturing, Product A & Product B. Product A, Production volume: 19,000 units Unit cost of direct materials and labor: ₹45 Product B, Production volume: 11,000 units Unit cost of direct materials and labor: ₹55 Manufacturing Overhead : Total manufacturing overhead costs: ₹30000 Factory supervisor salaries: ₹80000 Further, as product B is more complex to manufacture and needs more attention, the company decides the salaries of the supervisor should be allocated with ₹30,000 to product A and ₹50,000 to product B. Now if we use Full-costing allocation method, we get Total cost of production for Product A: ₹55 Total cost of production for Product A: ₹65 Using ABC method, Product A, Allocation of factory supervisors: ₹30000/19000 = ₹1.6 Manufacturing overhead to be applied to total production volume: ₹2,20,000/30,000 = ₹7.3 Unit cost of manufacturing overhead: ₹1.6 + ₹7.3 = ₹8.9 Total unit cost of production: ₹45 + ₹8.9 = ₹53.9 Product B, Allocation of factory supervisors: ₹50,000 /11,000 = ₹4.5 Manufacturing overhead to be applied to total production volume: ₹2,20,000/30,000 = ₹7.3 Unit cost of manufacturing overhead: ₹7.3 + ₹4.5 = ₹11.8 Total unit cost of production: ₹55 + ₹11.8 = ₹66.8 This proves that, ABC analysis shows that the total cost of production for product A is actually ₹53.9 per unit, not ₹55 as originally calculated. Product B costs ₹66.8 instead of the previous ₹65. These variations in prices of production have implications for profit forecasting, production planning and budget for marketing campaigns. Instances where ABC Analysis will create complications, When we take the above example with only one product or overheads are relatively small or no allocation done on supervisory salaries based on product's complexity, there is no need of ABC Analysis. When the product range is large, cost accumulation and data collection are complex and requires an advanced cost recording system and properly trained staffs. When it is difficult to assign cost to different activities.