What is Activity Based Costing?

ABC is a system of costing that allocates indirect and overhead costs to the activities that generated them. This is undoubtedly the biggest advancement in accounting in the last fifty years. The benefits of applying ABC include:

Improved make/buy, estimating and pricing decisions since you have a truer picture of your real cost.

Provides insight into the causes of overhead by giving you a whole new way to look at the causes of overhead.

Eliminates waste by identifying low value processes.

Most importantly, ABC encourages the continual improvement of business systems by focusing on the processes that produce cost. Continual improvement is your only safe option to avoid being put out of business by more efficient competitors.

Traditional accounting systems assign costs either directly to cost of sales or various overhead departments. What ever attempt that is made to allocate overhead departments to cost of sales is done based upon some variable such as direct labor divided by total labor. This thinking is usually flawed since direct labor costs usually have nothing to do with why the overhead cost was incurred. Arbitrarily assigning overhead costs has resulted in management getting rid of profitable product lines and keeping unprofitable ones.

ABC works by defining the processes that cause costs to be incurred and assigning costs that are 'driven' by these events. The objective is to assign all costs by the work units done rather than a cost category. Office supplies for example might be allocated between the purchasing system based on numbers of invoices paid and the sales system based upon the number of customer billings. This gives management a truer picture of what it costs to process a customers order and what it costs to purchase goods.

ABC was originally developed in the 70's for manufacturing companies. The wide spread use of computers in the 80's has led it be adopted for service industries.

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