How to understand the fundamentals of activity-based costing

Understanding the costs of the individual services your organisation delivers is a critical component of operating a sustainable business.

Payment for individual services under the NDIS makes it vital that you are pricing services correctly to make sure you are covering all costs. If not, then you may need to cross-subsidise some services. This is the practice of charging higher prices to one type of customer to artificially lower prices for another group.

Activity-Based Costing is relatively easy if you deliver a single service. It involves estimating your total costs and expected activity levels. The same process applies for costing multiple-services, but this requires a more complicated process of cost allocation across the service group.

It is the responsibility and prerogative of organisations to manage their finances as they choose. Each organisation needs to decide on the most appropriate costing method to suit their circumstances. Organisations are encouraged to obtain external advice if necessary, in reaching that decision.

Agree on units of measure

A unit of measure is a standard convention used in accounting. It is how you describe each product or service you offer. Before you can measure unit costs, you need to decide what a unit is. In some cases, this can be simple - e.g. one hour of someone's time. In other cases, it can be more complicated, as in calculating the cost of a group outing.

Start by identifying all activities that are necessary to deliver a product or service. It’s helpful if you align this to what the client is paying for.
Describe each item and assign a measure; one hour of care, a two-hour group activity etc.

Deciding on a measure can become complicated depending on how detailed you choose to go. You may need to balance complexity and cost over accuracy.

You may decide to describe units of measure in the same way as the NDIS or other funders. This may create difficulties for you if their descriptions change. It also may be less flexible. Whatever measures you use internally, you will need to map services to the NDIS to identify the price gap.

Decide on how you allocate costs

Separate each activity into its own cost pool, which is a group of individual costs associated with an activity.

Decide on which functions, business units or facilities are essential to delivering a service. These are direct costs.
Identify your overheads - the ongoing expenses of operating a business such as lighting, equipment etc.
Agree on which costs are fixed costs and which are variable. Fixed costs stay the same whether a service is delivered, whereas variable costs rise and fall with the number of units or services you deliver.

Deciding on how you allocate and assign costs is an essential choice to make regarding how you collect and treat data.

Estimate activity levels

By undertaking Activity-Based Costing, you are trying to identify the cost of providing one unit of measure for each type of service.

To accurately allocate and assign costs you will need to work out how many units of measure you are likely to deliver. Remember, this is not how much you could provide but the amount you are expected to deliver.

There are many estimating methods with different levels of complexity. Reviewing past performance of service delivery is a good starting point. Before embarking on ‘what if’ scenarios, it is wise to understand current activity levels, incorporating fixed and variable costs.

Review historical outcomes

The first place to go when estimating future expense levels is historical budget/actual data. Look at what you spent over previous years to see if that activity will be repeated this year.

It is unusual for costs to decrease over time so planning for increased costs will provide a better estimate over time. These may be known increases in expenses, capital outlay or maintenance costs that need to be factored into your future costs.

Activity-Based Costing is based on expected future operational outcomes so approximations should align with your estimated budget activity.