What it means
Traditional accounting groups costs by department or by type, such as salaries, rent and utilities. That tells you how much the warehouse costs but not how much it costs to handle one order.
Activity accounting reorganises the same costs around the work that is done. The first step is to list the main activities in a process, such as receiving goods, picking orders, packing and invoicing.
Next, the business assigns costs such as staff time, equipment and space to each activity. Finally, it chooses a cost driver for each activity, which is a measurable factor that causes the cost to rise or fall, such as the number of orders.
Dividing the cost of an activity by its driver volume gives a cost per unit of activity. For example, if order processing costs $180,000 a year and the company handles 6,000 orders, each order costs $30 to process.
Seeing a figure like that makes it easier to price services, set minimum order values and judge whether a process is efficient. Managers often classify activities as value-adding or non-value-adding.
Value-adding activities are those customers would pay for, such as making the product, while non-value-adding activities include rework, waiting and excess movement. Reducing the second group cuts cost without harming the customer.
Activity accounting is closely linked to activity-based costing, which uses the same activity cost rates to assign overhead to products and customers. It takes effort to set up and maintain, so it works best where overheads are large and activities differ widely between products or customers.
For small, simple businesses, the extra detail may not justify the work. Information systems have made this easier.
Time-tracking tools, workflow software and enterprise systems record how often activities happen, so the volumes behind each cost driver are available without manual counting. The harder task is agreeing with managers which costs belong to which activity.
In practice
Real-world examples
Example 1
An online retailer calculates that processing a return costs $12, compared with $4 to process a normal order. It adds a returns fee for customers who return items repeatedly. The change reduces the cost of low-value returns and encourages shoppers to order the right size first time.
Example 2
A bank assigns costs to activities such as opening accounts, handling calls and processing loan applications. It finds that loan applications for small amounts cost nearly as much as large ones. It raises its minimum loan size to protect margins, and it refers smaller borrowers to a cheaper online channel.
Example 3
A hospital analyses the cost of activities like admission, imaging and discharge planning. It discovers that discharge paperwork delays cost thousands of dollars a week in unused bed capacity. It redesigns the process to cut waiting time, which frees beds for new patients.
Think of it
Activity accounting traces costs to the activities that cause them-understanding what drives costs.
Formula
Calculation
Activity cost rate = Total cost of the activity / Total volume of the activity driver
A distributor spends $180,000 a year on the order processing activity, covering staff, systems and supplies. It handles 6,000 orders in the year. Activity cost rate = $180,000 / 6,000 = $30 per order. A customer who places 40 small orders a year therefore causes $30 x 40 = $1,200 of processing cost.Case study
Seen in the real world
Pioneer Wholesale is a fictional supplier of office products that, in this illustrative story, believed all its customers were equally profitable. Its accountant used activity accounting to calculate the cost of key activities, including a $30 charge for each order processed and $45 for each delivery.
The analysis showed that one group of small customers placed an average of 50 tiny orders a year, each worth about $60. The processing and delivery cost of $75 per order exceeded the gross profit on each order, so these customers were losing money.
Pioneer introduced a minimum order value and a delivery fee for small orders. Some customers left, but most moved to fewer, larger orders, and total profit rose by 8% in the first year. The accountant then repeated the exercise for the delivery and returns activities.
Watch out
Common mistakes
- Choosing a cost driver that does not really cause the cost. If the driver is wrong, the cost per activity will mislead.
- Defining too many activities. A long list creates a heavy reporting burden without adding insight.
- Using activity costs once and never updating them. Costs and volumes change, so rates should be reviewed regularly.
Questions
People also ask
How is activity accounting different from activity-based costing?
Activity accounting is the broader practice of tracking costs and performance by activity. Activity-based costing specifically uses those activity costs to assign overhead to products or customers.
What is a cost driver?
It is the factor that causes an activity's cost to increase, such as the number of orders, setups or inspections. Choosing the right driver is the key step.
Does it only suit manufacturers?
No. Service firms, banks, hospitals and retailers can all use it. Anywhere that overhead is large and varied, it can reveal hidden costs that departmental budgets never show.
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