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Activity-based costing

When and how should activity-based costing be applied?

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Contents

Activity-based costing (ABC) is a methodology for assigning costs to products or services based on the resources they actually consume.

Activity-based costing (ABC) assigns costs to products or services according to the resources and activities they actually consume. Earlier accounting systems commonly distributed overhead across product lines in proportion to a direct-cost measure such as labour hours. Although easy to administer, that approach could seriously distort the cost of making individual products. ABC is designed to correct those distortions.

When to use it

To establish a more accurate view of the cost of manufacturing each product.

To allocate shared overhead more credibly in complex production settings where many products draw on the same inputs.

Origins

ABC has intellectual roots in George Staubus’s work on activity costing and input-output accounting. Its modern development is also associated with Keith Williams, then a cost-accounting manager at John Deere. In 1984, Williams tested a different way to allocate overhead; within several years, the resulting cost information proved sufficiently useful for the method to spread to companies including GM and Weyerhaeuser. The approach then attracted the attention of Harvard professor Robert Kaplan and Robin Cooper, who helped establish the name “activity-based costing.” Their research, teaching and publications accelerated its adoption, and ABC became a standard method for assigning costs in manufacturing environments.

What it is

ABC produces a more realistic unit-cost estimate by connecting overhead to the factors that cause it. Under traditional absorption costing, utilities, building maintenance and head-office functions such as marketing or customer support are allocated to product lines using a direct-cost base. This was more defensible when materials and labour represented most manufacturing expenditure and indirect costs were relatively modest. Automation, greater product complexity and customisation changed that relationship: two products with comparable direct costs can demand very different levels of overhead.

Consider a standard machine assembled on an automated line and a customised machine that consumes roughly the same materials and labour. The customised version is likely to require substantially more design work, testing and quality control. Allocating overhead from direct costs alone would therefore overstate the standard machine’s cost and understate the customised machine’s cost. Those errors can lead to poor pricing and investment choices and, ultimately, weaker profitability.

How to use it

ABC starts by analysing the activities performed in an operation. Costs are grouped into activity cost pools, the drivers of those costs are identified, a rate is calculated for each driver and the relevant costs are then assigned to products. The following quality-control example shows how the method allocates one category of indirect cost:

Identify activities and cost pools: Manufacturing overhead is generated by activities such as building repair and maintenance, sales, marketing and quality control. Quality control exists to ensure that products meet customers’ required standards. Its cost pool combines the salaries of quality engineers and other quality staff with the tools and materials used in their work. Assume this pool totals $300,000 a year.

Find the cost driver(s) for each activity: Determine what causes the quality-control workload and its cost to increase. Production volume might initially appear suitable, but investigation shows that the number of quality inspections is the relevant cost driver.

Determine the cost driver’s rate per activity: Suppose custom machines consume 75 per cent of the quality-control pool even though they account for only 10 per cent of factory output. If 1,000 custom machines are produced, the quality-control rate per activity for that line is ($300,000 × 75 per cent) ÷ 1,000 = $225.

Assign the cost driver’s costs to that activity: A simple volume allocation across ten thousand machines would assign only $300,000 ÷ 10,000 = $30 to each custom machine. That figure materially understates the quality-control resources the custom line actually uses.

Calculate the true production cost per unit: If absorption costing reports a unit cost of $1,000, ABC revises it to $1,000 + ($225 − $30) = $1,195. Management may consequently discover that customised machines are underpriced while standard machines are overpriced.

A complete ABC analysis reveals how each product consumes overhead. Managers can then reduce costs by managing the underlying drivers. For example, the company might be able to perform fewer inspections on customised machines without compromising final quality, freeing quality engineers to work on other priorities.

Top practical tip

Implement ABC through a controlled pilot before extending it across the organisation. The method requires a detailed decomposition of activities and may meet resistance from people accustomed to the existing system. Running both systems in parallel during the pilot makes the results easier to compare and validate. Specialist support can also help the team learn the methodology and design the first model correctly.

Top pitfall

Do not treat ABC as a quick fix. After its rapid adoption in the 1980s, the method drew criticism in the 1990s when organisations struggled to apply it well. Familiar systems were difficult to relinquish, and the new techniques demanded learning and behavioural change. ABC delivers value only when the organisation invests the time, adjustment and skill needed to operate it effectively.