What is Activity Based Costing?

Activity Based Costing, which is often referred to as ABC, is an accounting method that assigns costs to products, services, projects or tasks based on the resources they consume and the activities that go into them. ABC contrasts sharply with traditional cost accounting that assigns costs using subjective allocation percentages for indirect costs like energy and marketing.

The ABCs of ABC

Traditional accounting uses standard business’s expenses to assume the costs, but ABC’s numbers are allocated in proportion to an activity’s direct costs. Traditional cost accounting falls short because two activities that require the same direct costs may have very different overhead amounts. To illustrate, mass-produced goods will use the same amount of labor and materials as a customized products, but the latter will use much more time to create than mass-produced ones. ABC is an alternative accounting concept that helps companies that deal in mass customization accurately understand and forecasts their costs.

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ABC vs. Cost Accounting

Let’s use a product manufacturing example to illustrate the differences between the two concepts. A corporation that manufactures parts through a sequence of machine operations will probably use both direct costs and indirect costs. Direct costs can be assigned to specific product units and will include direct materials and direct labor costs. For example, direct labor costs are quantified through the cost for an employee to run a production machines every hour. Direct materials costs are quantified through individual units. Indirect costs cannot be specifically assigned to the production of items. Instead, these costs are used to create batches of units, such as machine set up, product packaging and machine maintenance.

Why ABC Matters

Companies use activity based costing because executives need better costing accuracy in order to understand their real costs and the true profitability. Understanding the exact ROI of individual products and services allows management to reduce waste, maintain feasible expenditures and manage labor and material costs. Companies that consistently and effectively use ABC will be able to proactively make the right decisions about market pricing, portfolio elements, adding or removing products and choosing between outsourcing and in-sourcing production. ABC goes hand in hand with process improvement initiatives and activity based management.

What are the Benefits of ABC?

Cost accountants all understand that traditional cost accounting practices may unintentionally obscure important financial information regarding the real costs of individual products and services. As a result, more and more companies are using ABC methods to better understand the true costs of individual products and services. Companies use ABC to isolate individual products or services that are unprofitable and to show what wasteful costs can be eliminated. Multinational corporations can identify the true costs of products to streamline production and outsource cheaper labor and materials. ABC isn’t directly related to traditional financial accounting reports like balance sheets, income statements and cash flow statements. However, it drives improvements in reported margins and profitability.

Activity Based Costing is an accounting tool used to increase the accuracy of various costs to improve decision making and strategic planning. Investopedia offers an in-depth analysis of ABC here.