@ International Journal of Project Management Vol. 17, No.1, pp. 61-67, 1999 {© 1998 Elsevier Science Ltd and IPMA. All Fights reserved Printed in Great Britain (0263-786399 $19.00 + 0.00 PII: $0263-7863(97)00073-2 Activity based costing for projects Tzvi Raz Faculty of Management, Tel Aviv University, Ramat Aviv 69978, Tel Aviv, Israel Dan Elnathan Faculty of Management, Tel Aviv University, Ramat Aviv 69978, Tel Aviv, Israel A generic activity-based costing model is presented. The model includes a cost allocation struc- ture designed specifically for projects, and a number of cost drivers for typical project activities. ‘A numerical example illustrates the benefits that ABC can provide. The paper concludes with a discussion of some issues involved in the implementation of ABC, and of activity-based manage- ment. ©) 1998 Elsevier Science Ltd and IPMA. All rights reserved Introduction ‘Over the past decade, the paradigm of Activity-Based Costing (ABC) has helped many manufacturing and service organizations improve their competitiveness by enabling them to make better decisions based on a bet- ter understanding of their cost structure. The main idea behind ABC is to classify indirect (overhead) costs and to allocate them to customer-required pro- ducts or services, based on the activities needed to pro- duce these products. In this manner it is possible to cost out the products more accurately and completely. In this paper we outline an activity based costing model for projects. The paper is organized as follows We begin with a brie! overview of Activity-Based Costing, followed by a discussion of the benefits it can provide to organizations engaged in projects. Then we present the cost allocation model, followed by some representative cost drivers and an example, We con- clude with some remarks on data collection and im- plementation issues and on the link between ABC and the project life cycle. Activity-Based Costing Models Activity-based costing (ABC) systems are now being adopted by many manufacturing and service organiz~ ations. Basically, ABC is a two-stage approach for allocating indirect costs to product units based on cost drivers at various levels of activity. In the first step, resource costs are assigned to cost pools which corre- spond to the various types of activities performed by the organization. Each type of activity is then costed out individually based on the total costs of resources consumed divided by the volume of activity performed, In the second step, activity costs are assigned to the products, customers, and services that benefit from or create the demand for the activities. Unlike previous costing models, ABC recognizes the fact that not all activities (and thus resource consumption rates), are proportional to the number of units produced. Whereas in traditional cost models, volume or volume- related measures serve as proxy cost drivers, ABC expands the set of potential cost drivers (the factors that affect the consumption of resources) to include factors that are not volume-related, yet they are directly linked to the activities performed in order to create and deliver the product or service. Such drivers include, for example, the number of purchase orde the number of parts designed, and the number of ma- chine set-ups ‘ABC systems in manufacturing organizations typi- cally recognize four levels of activities: unit, batch, product-sustaining, and facility-sustaining, ‘At the unit level, resources are consumed in activities such as assembly and individual testing of each unit These are activities that are required for the pro- duction and delivery of each and every unit. At the batch level, activities include setups for production runs and sample testing of a pre-determined number of units. The number of batch-level activities required by each batch does not depend on the number of units in the batch. Different batches may include a different number of units, and the apportioned setup cost per unit will decline with an increase in the number of units in the batch Above the batch level is the product sustaining level. The product sustaining level includes activities such as product design and materials procurement. Each pro- duct requires design work, irrespective of the number of units which will be produced or the number of batches. The last (highest) level is the facility sustaining level. It encompasses the many products that may be produced in the same facility. Facility-sustaining activi- ties include general plant maintenance and facility ad- ministration, 6Activity based costing for projects: T. Raz and D. Enathan Once the activities in each level are identified, allo- cation bases which are the actual cost drivers or proxy measures are selected for each activity. The costs as- sociated with each activity are accumulated over a period of time (typically a quarter or a year), and the cost per allocation-base unit is calculated (e.g. cost per setup at the batch level, or cost per unit at the unit level). The cost of a product or a service is then caleu- lated as the sum of the costs of all activities which were included in its production or service delivery at the various levels. Thus, with ABC costs are attached to products in a way that reffects how the products consume the resources that comprise the organization's overhead. This process is illustrated in Figure 1, which shows how costs flow from resources through the ac tivity pools that consume them and eventually to the various levels of the product Benefits of Activity-Based Costing ABC systems address the pricing distortions which exist in traditional cost systems. In the current global economy, being competitive in the price dimension is paramount for the firm’s long term survival, and that requires more accurate determination of the costs of its products and services. Two important develop- ‘ments: (a) the increased proportion of overhead costs. out of total costs; and (b) the increased variety and complexity of the products that the markets demand. require solutions which the traditional systems could not provide. Overhead allocations are always estimates, but with the increased proportion of overhead costs out of total costs, the need for more accurate allocations is greater, because any error in allocation is magnified many-fold. / a, Figure 1 Cost allocation flow 62 C/™ A °) + Also, traditional cost systems which allocated overhead using volume-related allocation bases (e.g. number of units, number of direct labor hours) were more suit able for mass production environments, where there was little variety and complexity in the products. Once the producis/services are offered in greater variety and become more complex. allocation of overhead costs to all units equally, as if they are consuming identical quantities of resources, is erroneous. It ignores the fact that, for instance, set-up costs per unit in a small batch are greater than set-up costs per unit in a large batch, or that a complex product consumes much more design and logistics resources than a simpler pro- duct (due to greater number of parts, more elaborate design, etc.). Cooper (1988)! describes in detail the conditions under which traditional costing systems will fail to correctly price products, underpricing. small, low-volume products at the expense of large, high- volume ones Issues in project cost estimation Organizations that are engaged in projects are keenly interested in accurate estimates of the costs of the pro- Jects. Contractors bid on projects and, once they win a ‘contract, have to execute according to the budget in their proposal. Thus, it is important for them to bid the correct price that will recover all their expenses, including the fair share of overhead, and allow reason- able profits while remaining competitive. Typical over- head ratios in projects are in the range of 20-40% of direct costs and include the costs of funetions such as marketing, purchasing, personnel management, general ‘management, ete Facility ‘Sustaining Product Sustaining Batch Unit foIn today’s highly competitive business climate, cus- tomers are critical of overhead rates, and they prefer to see explicitly what they are being charged for. By justifying the costs charged based on activities per- formed, the ABC approach provides a sound frame- work for communicating the nature and extent of indirect costs, and brings about a reduction in the per~ centage of costs that are ultimately charged to the cus- tomer as general overhead. The allocation of indirect costs throughout the pro- ject budget has concerned the project management profession for quite some time, As early as 1967, the United States Department of Defense issued the Cost Schedule Control Systems Criteria, which, in its Planning and Budgeting section, defined three types of project costs. These types are direct costs, which they call measured effort, and two types of indirect costs, apportioned effort and level of effort (LOE), Apportioned effort refers to costs that are allocated to project activities in direct proportion of their measured effort. Level of effort refers to costs that are allocated to project activities based on their time duration. Thus, without explicitly using management accounting terminology, C/SCSC recognized two cost drivers for overhead allocation: direct cost and activity duration This is one step better than the traditional approach of allocating overhead based on direct costs only, but far less accurate than modern approaches such as ABC A project is a “temporary endeavor undertaken to create a unique product or service” (Project Management Institute, 1996).> The term ‘unique’ in this definition implies ‘that at least some part of the project is new and has not been done before. This may pose some problems in the estimation of the costs of activities that have not been done before and conse~ quently there is no historical data about them to draw upon. The activity analysis required for ABC can assist in this respect. Consider an organization that does most of its work in the form of projects, By analyzing the activities to a sufficient level of detail, the commo- nalties among the various projects become apparent. It is then possible to view each project as a unique com- bination of activities, the vast majority of which have already been done as part of other projects, rather than a combination of unique activities. Since the basic activities that constitute the project are done repeatedly for the various projects that the organiz~ ation is engaged in, it is possible to rely upon standard cost data to generate cost estimate. By considering projects as made of unique combinations of standard work components that appear in multiple projects, it becomes justifiable to invest the effort required to obtain more accurate cost estimates. By following the ABC paradigm of defining activi- ties at various levels of a hierarchy of activities and assigning costs to them accordingly, it is possible to reduce the proportion of cost that is allocated as over- head and to move towards a larger extent of direct costing, with the resulting advantages as far as accu- racy and manageability From the above discussion we see that projects exhi- bit the two characteristics of modern manufacturing organizations that prompted the development of ac~ tivity-based costing: a high proportion of indirect costs and significant complexity and variety. Consequently, it is worthwhile to examine the applicability of ABC Activity based costing for projects: T. Raz and D. Elnathan to project cost management. To apply ABC to the pro- ject management environment, we must have a hier: archical framework that supports the allocation of costs to levels based on the activities that are required at cach level. There are two possible approaches: either use an existing hierarchical structure, or develop a new one specifically for this purpose, We will examine both possibilities below. Existing structures for cost allocation The main hierarchical structure that is associated with project planning and control is the Work Breakdown Structure (WBS). The WBS is an exhaustive and mutually exclusive decomposition of the work contents of the project into a number of work elements. Each work element can in turn be further decomposed, up to the lowest level of the structure, which is the work package level. Each work package represents a dis- crete, well defined effort under the responsibility of a single individual or group in the project team. Detailed cost estimation is done from the bottom up, starting with estimates for each of the work packages and sum- marizing the costs upwards through the structure up to its root, which is the clement that represents the entire project. Being a task oriented structure, the WBS would seem well suited to serve as the basis for the ABC hier- archy. However, because the WBS provides an exhaus- tive decomposition at each level, there are no provisions for activities to be executed at levels other than the lowest level—the work package level. Consequently, it is not possible to assign costs to a level other than the work package level. There are several approaches for developing a WBS for a project. Globerson (1994)° mentions that the main two approaches are the product oriented WBS and the process oriented WBS. There are no clear cut accepted rules for determining the number of levels of the WBS or the number of branches at each level Consequently, WBS may differ widely as far as their topology. making it difficult to apply a consistent cost- ing approach, ‘Another hierarchy that may serve as the basis for based cost estimation is one based on the structure of the product or products that are expected from the project. This will be similar, if not identical, to the product Bill Of Materials’ (BOM), which describes the product in terms of its assemblies, sub- assemblies and basic parts. For ABC purposes, we could associate with each basic part the activities required to produce or acquire it, and for each sub- sequent level in the BOM hierarchy (subassembly. assembly, subsystem, system, etc.) we would add at the appropriate level the activities required to put together that particular element from its constituents. The use of the BOM as the hierarchy for cost allo- cation may appear appropriate, since it is oriented to the project results. which is what the customer ulti- mately pays for. Being focused on the product that will be produced by the project, the BOM structure is well suited to capture direct cost data, but it does not address explicitly the various overhead activities that are the focus of ABC. Also, the BOM may have any number of levels, depending on the complexity of the product and on the manner in which it is produced 6B