Activity Based Costing is a method for developing estimation for cost in which the construction project is subdivided into discrete, quantifiable activities. The activity should be definable where productivity can be controlled in units.
After the construction project is decomposed into its activities, a cost estimate is prepared for all project activities. These single cost estimates will contain all materials, labor, equipment, and subcontracting costs; including overheads for each activity.
Each complete single estimate is added to the others to obtain a total estimate. Contingency and Escalation can be calculated for each activity or after all the activities have been summed. ABC costing is a very powerful tool, but it isn’t appropriate for all cost estimates.
Activity Based Costing vs. Traditional Costing
ABC is a costing method that is different from traditional costing. Based on a cost driver, traditional costing applies an average overhead rate to direct production costs (e.g., hours or volume). However, some production-related activities incur more overhead expenses than others. As a result, traditional costing can result in an inaccurate cost of making each product.
Traditional costing is simpler but less specific than activity based costing. You might consider proceeding with traditional costing if you only make a few products.
You may also use traditional costing for reporting externally (e.g., to investors) and ABC costing for reporting internally (e.g., to managers).
Activity Based Costing Methodology
Construction firms have collected cost data from a multitude of different construction projects. The amount of work associated with this cost was also collected with the cost data. For example, collected data included the cost of the material, labor, equipment, and overheads required to paint a room, whilst noting the surface area painted. This best practice allowed construction professionals to obtain a cost per area as well as labor resources per area.
ABC Costing equation:
C/A = HD + M + E + S
Where C/A = Estimated cost per activity
H = Number of hours of labor required to perform the activity once
D = Wages per labor hour
M = Costs of material required to perform the activity once
E = Costs of equipment to perform the activity once
S = Costs of subcontracting to perform the activity once
The activity total cost will be based on the number of times the activity is performed during a specific time frame. Cost estimators, or QS engineers, have collected large databases of activity-based cost information.
Use of Activity-Based Costing Methodology
Activity Based Costing methodology is used when a construction project can be divided into defined activities.
These activities are at the lowest function level of a construction project where costs are monitored and performance is evaluated.
Depending on the project organization, the activity may coincide with an element of the work breakdown structure or may combine one or more items of the WBS. However, a clear definition of the activities must be set so there is no overlap between them. After defining the activity, the unit of work is established. All activity costs are estimated using the unit of work.
The estimation of work units can be achieved by performing detailed estimates, using cost estimating relationships and obtaining outside quotes for equipment, etc. All costs include overheads, markups, profit, and should be encompassed in the activity cost.
Identification of Activities in ABC Costing
When you start to define a single activity, the cost estimator must balance the need for accuracy with the amount of time available to prepare the estimate. A cost estimator may be able to develop an extremely accurate cost estimate by defining smaller activities; however, the amount of time required to prepare ABC estimates for each activity may not justify the increased accuracy.
The total estimated cost of the construction project may be sufficiently accurate if 10 activities are used instead of 15. On the other hand, trustworthy cost information may not be accessible if the activity categories are too general. Since the basis for the cost estimate is the activity, it is very important that the activity is selected correctly
Activity-Based Costing in Construction Project Management
Construction projects involve many activities. These activities consume a variety of resources (such as materials and labor). The consumption of these resources adds to the overhead costs. Activity-based costing is a costing technique that determines the cost of activities without distortion.
Activity Based Costing will identify these activities. The resources involved in every activity shall be identified and the cost of each resource shall be determined using the receipts of purchase.
The cost per unit of material must be determined, as well as a list of activities that must be performed to complete a job. The resource consumption of each activity must be determined.
The cost per unit of material is multiplied by the amount of each material used in the activity, which results in the overall cost of the materials. The total cost of material can be obtained by adding direct labor and overhead costs to the overall cost of the material.
The ABC costing methodology is common because it recognizes the relationship between costs and activities.
This makes overhead allocations less arbitrary. One of the problems facing ABC costing is identifying activities that use resources. ABC costing software programs are available on the market (such as SAS ® Activity-Based Management). They assist the users to make informed decisions.
Pitfalls of Activity Based Costing
Activity-based costing frequently fails because project managers ignore the cardinal rule: it is preferable to be approximately correct rather than precisely incorrect. When it comes to ABC costing, close enough isn’t just good enough; it’s frequently the key to success.
Companies that use activity-based costing run the risk of spending too much time, effort, and even money obtaining and analyzing data. Managers participating in ABC costing may become frustrated if there are too many details.
In order to adopt ABC costing, specific systems must be in place, which may be costly as compared to the standard/traditional method. Another limiting element is ‘time,’ as projects are typically completed at such a fast rate that the project manager does not have the time to perform proper activity based costing.
Despite the fact that Activity Based Costing has been around for over a decade, it is continually evolving. However, the transition of companies to ABC costing systems in the next ten years is not so much a question of if, but when.
Despite the fact that many companies have tried ABC costing and then abandoned it for a variety of reasons, ABC costing data is far more important to emerging management styles, which are more process-oriented and customer-focused than the traditional silo organizations supported by traditional accounting practices ten years ago.
The information provided by traditional cost accounting data is always poor and inaccurate. Managers are realizing that their departmental cost reporting is poorly supported as organizations focus more and more on customers and value-delivering processes.