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Activity-Based Management (ABM): Definition & Examples

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Lesson Transcript
Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

This lesson explains the concept of activity-based management and how it extends the use of activity-based costing. Learn how this costing method is used as a comprehensive management tool to reduce costs and improve processes and decision-making.

What Is Activity-Based Management?

A machining company called Arrow Machine Service has three machining processes: micro, traditional, and non-traditional. Management wants to know which of their products and services makes them the most profit.

To get them the answer, we have to determine our costs, so where do we begin? If we want accuracy, we need to start with activity-based management.

Activity-based management is a type of analysis that helps an organization determine its strengths and weaknesses, including where it is losing money, time, and effort. The analysis looks at which production activities add value to the company and which ones don't. Then, management can make decisions on whether to enhance, streamline, or even cut certain activities.

For example, with Arrow Machine Service having three machining processes, an accountant would look at the total number of orders that need to be filled, the amount of time it takes for each process, the expense associated with taking apart and assembling equipment, and the labor rate for each machinist during each activity. By looking at each activity, management can decide which activity needs to be improved, eliminated, added, or changed. This, in turn, will increase Arrow Machine profits.

Activity-based management uses activity-based costing to determine the costs of each activity. Let's dive into this type of costing and compare it to traditional costing methods.

What Is Activity-Based Costing?

Activity-based costing is when a company assigns indirect costs to specific goods and services. Indirect costs are things like office supplies, administrative support, rent, utilities, and any other expense that is jointly incurred, meaning it is difficult to trace. You may also know indirect costs as overhead costs. They aren't tied to a specific function with a traditional costing method, but the goal of activity-based costing is to tag them to a specific activity.

The objective of activity-based costing is to reduce costs and increase value, quality, and efficiency by assigning indirect costs to a cost object like a department, subsidiary, franchise, or product. This means that instead of using an overall overhead rate for the entire facility, we can be more precise in our calculations and calculate overhead rates for specific costs objects, like products or services. Let's look at the differences in calculating Arrow Machine Service's costs and pricing with activity-based costing versus a traditional costing method.

Traditional Costing Method Example

When using a traditional costing method, overhead is simply an overall overhead rate multiplied by the number of labor hours needed for the project. This is a simple way for an accountant to determine costs.

Using a traditional costing method, let's look at Arrow Machine Service's total estimated cost of an order for crankshaft repairs.

Arrow Machine Service had an average of $3,000,000 in overhead costs for the past 2 years. Each year, the company used 20,000 labor hours. This gives us an overhead rate of $150 per labor hour (that is: 3,000,000 / 20,000). The crankshaft order will take 110 hours. This gives us a total cost of overhead as $16,500 (150 * 110). To estimate total costs, what we should charge, and a total sales amount, we have:

Direct materials: $35,000
Parts: $25,000
Labor: $40,000

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