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Activity-Based Costing (ABC)

Understanding What Really Drives Costs

Assigning costs fairly can help boost profits.

Whether you manage an organization, a department, or a project, one of your principal objectives is to be as profitable as you can. To accomplish this, you'll probably seek to minimize your costs and other outgoings.

In practice, you may be able to contain your direct costs by keeping tight control of your supplies, or by using your labor hours very efficiently. But you'll also need to take into consideration the indirect costs that are shared across the company. For example, how do you track the cost of shared overhead expenses like customer service, maintenance, or insurance?

The full cost to build a specific product, run a specific project, or even manage a specific department includes all of the direct costs associated with it – plus a fair share of other indirect costs. However, the idea of what's 'fair' isn't always clear.

In this article you'll learn about a model for overhead costing – Activity-Based Costing – that calculates the true, 'fair' costs.

The 'Real' Costs

Let's imagine you manage a computer repair company. Some jobs you carry out may require you to run and maintain expensive equipment, while others may not. Therefore, you may end up assigning expenses like maintenance and depreciation 'unfairly' if you apply these costs evenly, or average them, across all the jobs you do.

In reality, even though two jobs may take the same number of direct labor hours, the other costs involved will be different. For the bottom line, this means that some jobs are more profitable than others. However, if you only take labor hours into consideration, you might not see that difference.

Traditional accounting systems address the issue of 'fair share' product costing by using an overhead rate to assign indirect costs. This overhead rate is reset periodically, and it's applied consistently to the various cost centers (which may be specific products or activities within the organization). Variables such as the amount of space occupied, the number of staff, or the quantity of material used are common bases of cost allocation.

For example, let's say you have three sales offices. The European office accounts for 42% of revenue, the office in Asia generates 37%, and the North American office provides the remaining 21%. You use sales volume as your overhead rate to spread the costs associated with customer service, marketing, and human resources.

The problem with bases like these is that, at the individual product or service level, some items are allocated too much cost, and some are allocated too little. In the 1980s, with the shift from labor-intensive to capital-intensive operations, these inaccuracies became more significant. This led to product lines being continued when, in reality, they were unprofitable; and to product lines being cut when they made a positive contribution to the bottom line.

As a result, Robert Kaplan of Harvard Business School developed a costing process to address the true cost implications for different products and services – rather than using simple averages, which may hide those true costs. He called his process Activity-Based Costing (ABC).

See Words Used In... Financial Accounting for a more detailed discussion of costs and expenses.

Activity-Based Costing

ABC isn't dramatically different from traditional overhead costing, because it also allocates indirect costs to various cost centers. However, ABC identifies many more cost 'activities' to use in the overall process of assigning those costs.

Let's explain that with an example: