Activity-Based Costing (ABC)

Understanding What Really Drives Costs

Assigning costs fairly can help boost profits.

© iStockphoto/3pod

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

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