Activity-Based Costing

• Pages: 12-14

Page 12

Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs. Costs are assigned to specific activities—planning, engineering, or manufacturing—and then the activities are associated with different products or services. In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly. Generally, activity-based costing is most effective when used over a long period of time.

Activity-based costing emerged in the 1980s as a way to more accurately measure all of a business's costs and associate them to the goods and services produced. Traditional cost accounting methods were designed for the companies operating in the early days of the 20th Century, a time when direct labor and materials were the two largest costs associated with producing goods and services. There was little automation at the time and overhead costs were very small as a percentage of total costs. Furthermore, most companies offered a narrow range of products and/or services. All this was changing by the middle of the century. Automation was being incorporated into all businesses and overhead costs rose as the support services needed to design and manage this automation were removed from the production floor. Yet traditional cost accounting methods stayed in place. Owners continued to measure primarily the costs of direct labor and materials; they allocated overhead costs somewhat arbitrarily. As overhead costs grew as a share of total costs, the distortions that this method introduced also grew.

Harvard Business School Professor Robert S. Kaplan was among the first to articulate a need for a more sophisticated system with which to more accurately allocate costs directly to the goods and services produced by that business. ABC is based on the principle that the majority of business activities support the production and delivery of goods and services. Therefore, in order to get a true picture of the cost of producing a good or service, one must allocate the costs of all business activity to specific products and services. The ABC method does this by assigning factory and corporate overhead, as well as other indirect resource costs, to activity categories. Then, an assessment is made as to how much overhead each product, product line, or...