Activity-based Costing (ABC)

Activity-based Costing (ABC) is a managerial accounting method that assigns costs to products and services based on the activities required to produce them. This approach contrasts with traditional costing methods, which often allocate indirect costs uniformly across all products, potentially leading to misleading financial insights. ABC identifies specific activities in the production process and determines their associated costs, allowing for a more accurate understanding of where resources are consumed.

By focusing on activities as the fundamental cost drivers, companies can better analyze their operations, identify inefficiencies, and improve decision-making regarding pricing, budgeting, and resource allocation. ABC can also support strategic planning by highlighting the profitability of individual products or services, helping organizations tailor their offerings to maximize profitability. This method is especially useful in industries with diverse products or services, where a more nuanced understanding of costs is vital. Overall, Activity-based Costing provides valuable insights that can lead to improved operational efficiency and financial performance.

Published in: 2021

By: Joseph Dewey, PhD

Subject Terms

Activity-based Costing (ABC)

Last reviewed: February 2017

Abstract

A company invests a specific amount of its own resource monies, called overhead, into its manufacturing processes, costs that in turn are recovered with a profit when the product itself moves into the marketplace for sale. Activity-based costing refers to the practice in manufacturing in which a company divides its total overhead expenses according to the individual products produced by that company and by the specific activities that the production entails as a way to define precisely the cost of each individual item produced.

Overview

At the center of the manufacturing industry is a competitive market price—that is, how much an industrial complex, such as a factory or a plant, can charge for its product(s) and maintain a stable market presence. If a product is sold too cheap, expenses will not be covered and the business will quickly fold; if the product is too pricey, competitors will get the sales and, again, the business will quickly fold. Further, setting an appropriate price is important as the only way for a business to maintain an appropriate profit margin that can in turn both maintain its operations and its staffing while providing sufficient excess monies for the company to pursue new ideas and to evolve its own operations for greater production and greater efficiency. At the center of that pricing determination is the actual costs of producing the unit (Lelkes & Deis, 2013).

In service based industries—law firms, for example, or medical facilities, restaurants and hotels, consulting firms, offices, or schools—determining the cost of specific activities is difficult, as what is being measured is real-time human effort. The process then depends on intangibles such as how quickly a person performs the job, how completely they understand the task, how much help they require, and how much that performance time varies from, say, a Monday to a Friday. In a manufacturing business—a plant or a utility or a factory—cost analysis can be far more regulated because so much of the process is done by machine and by workers who perform the same reliable resource activity every day. That makes costing more accurate and allows for careful management of operating expenses and efficiencies (Kapic, 2014).

Like all businesses, manufacturing businesses need to make money—and that money comes from the competitive market price it can charge. Whether a manufacturing plant produces light bulbs or socks, accountants keep a careful eye on all aspects of the production process to be able to report accurately and efficiently on how much the processes are costing the company. Accurate reporting enables the company to not only evaluate the efficiency of their staff but also set a workable and competitive price for the manufactured product.

Critical to establishing fair market prices for their employer’s product is the accountant’s ability to determine with certainty how much the company is actually spending to produce it (Park & Simpson, 2008). The production of a single unit involves a number of related steps and activities that collectively work together to move that process forward. In an efficient process, the end product could not be completed without each of these activities—one could be trimmed or cut or discontinued. These processes include setting up the machines that actually do the work; calibrating those machines for accurate results; packaging the final product; initially feeding the machines with appropriate raw materials; unloading those raw materials and preparing them for use; inspecting the final product for any obvious defects; maintaining the computer programs and technical support necessary to run the machines; generating the utilities necessary for a product run; and maintaining essential security to ensure the process is not compromised either by human agency or by some cataclysmic act of nature.

Any one unit of production involves many activities, some done by workers, some completed by computerized robotics under the direction of staffing. These cost activities are termed “cost pools,” and resource money must be allocated for each process. “Cost objectives” are the goals of the entire manufacturing process—that is, where the money is broadly going. Costing then examines the specific mathematical relationship between money allocated, the activities engaged, and the unit ultimately produced (Wei Tong Chen, 2016).

Traditional costing simply divides, or allocates, the overhead expenses as equally as possible between or among the units being produced by the plant. Accountants would simply take the total number of man hours, the total cost of materials, and the total machine hours and and divide that number evenly by the total number of products the plant produced. The problem, of course, is that not every unit being produced by a plant requires an identical investment of time, staff, and work. Different products demand different investments of the company’s resources, and to arrive at an accurate cost for the unit requires that the accountant taker a close and critical look at exactly those processes to determine which unit products require what activities and then divide the overhead proportionately to reflect more accurately the company’s financial stake.

In turn, the company can charge a price that is far more in keeping with its own expenses. ABC, in fact, allows a company to actually assign its spending to the products that actually require the processes that are being paid for—that is, budgets and consequently costs can be made proportional. A company will know more accurately what its products are actually costing them. (Tsai et al., 2015). More important, by using ABC, rather than traditional, far simpler allocation costing methods, a company can actually scrutinize its own manufacturing processes to determine with a greater degree of accuracy where its own operational efficiency can be improved.

Applications

Activity-based costing can be applied successfully to industrial plants responsible for producing a wide range of products, often during simultaneous runs during the same shift or alternating runs during concurrent shifts. To appreciate the fundamental difference in the logic and premises between traditional costing and applying ABC, suppose a factory runs seven days a week, around the clock, and manufactures just two types of socks. One is a basic white tube sock that comes in a limited range of sizes designed to generally accommodate any age and can be worn by either gender; the other is a colorful winter sock, called a cabin sock, that comes in seven different sizes and are designed specifically for women to provide both warmth and style. From an accountant’s point of view, the determination of cost per unit is problematic.

Say the factory with its two products maintains just over $2 million annually in overhead—that is, its general operating costs. Annually the company produces just under twenty million units of the basic white cotton tube socks. Although the runs involve the same staff and the same machines, the winter sock is more time-consuming. The cabin socks are double woven for extra warmth and insulation; the socks are treated with dyes to create colorful patterns; they are composed of a mix of nylon and acrylic and polyester for durability; the socks are aloe infused to provide additional comfort; each sock is given skid-resistant pads to minimize the chance of slipping; and each sock sports the company’s elaborate logo. Each stage necessitates machine resetting and far more care in inspecting the finished product to ensure quality. In addition, because the orders for such high-end products is, not surprisingly, lower than the demand for the lower cost tube socks, the machines are not constantly engaged. Thus, the company produces only two million units of the cabin socks each year.

The tube socks, which are high volume products, can be run with little staffing interference—the pattern is simple, the colors uncomplicated, the weave basic. In fact, the machines that produce the tube socks run virtually continuously with few breaks for maintenance and occasional changes to produce a different size. The process goes night and day—workers are there largely to implement a general quality check and to monitor general safety and to ensure appropriate packaging.

Under traditional cost analysis accounting, the total amount of overhead, $2 million, would simply be divided in half because the company produces just two lines of socks and in turn the cost per unit would be determined. The company would be estimating the cost of the cabin socks based on the erroneous assumption that the company was putting in the same amount of time and effort into producing that specialized product that it was expending to produce its higher volume tube sock product line. Thus, when the socks got to market, the cabin sock would be sold for a price far below what it actually cost the company to produce it. At the same time, the basic white tube sock would be priced far in excess of what it cost to actually produce and, in turn, would not be competitive with other basic white tube socks being produced by competitors.

Under the ABC system, however, accountants determine that 62 percent of the company’s time and resources actually go into producing the high-end, low-volume cabin socks; while only 38 percent of the company’s time and resources go into producing the low-end, high-volume tube socks. Accountants can only determine those percentages after carefully reviewing data meticulously kept by the employees and by checking the data generated by the machines themselves. By allocating which activity in each production run actually takes the overhead costs—that is, by actually assigning a hard figure to the activity itself—and what percentage of total overhead costs are incurred by that activity, accountants can present the company with a far more accurate and far more precise measure of company investment. Costs are assigned entirely by what the product consumes.

Whatever the product, different product lines require different measures of basic resources, different machinery activity, different utility and power intakes, different levels of quality and safety scrutiny, different methods of packaging, different levels of hands-on operation from staff, different levels of supervision and computer settings, different levels of product testing. The more diversified a company is—that is, the more varied its production lines maintained within the same physical plant—the easier cost are to blur, making the definition of an appropriate range of product pricing that much more difficult. Indeed, those operations within a company charged with actually setting market prices—marketing, for instance, or sales and promotion—can only do that effectively if accountants provide the most accurate costing information. “This information allows managers to reduce costs by designing products and processes that consume fewer activity resources, increasing the efficiency of existing activities, eliminating activities that do not add value to customers, and improving coordination with customers and suppliers” (Ittner, Lanen & Larcker, 2002).

Viewpoints

Although ABC would seem plain common sense if a company wants the most precise spending figures and in turn wants to bet competitive in the open marketplace, many companies nevertheless opt not to follow activity-based costing. This accounting method is time, labor, and data-intensive to the point of being prohibitive for smaller scale manufacturing firms (Ness & Cucuzza, 1995). To derive an accurate and detailed ABC schema, the accountant would need significant data from supervisors on the shift, from the computer-driven machines involved in the process, and from the workers themselves.

The process of producing a single unit would then have to be carefully parsed into its specific elemental steps, carefully separating each despite their obvious linkage. Only then can an accounting system allocate the appropriate costs. The time that requires often creates an accounting department that becomes too hands-on in the manufacturing process. Without an organizational structure and management expertise to assimilate and make efficient use of the information itself, such crossed lines of authority can lead to confusion and an uncertain chain of command. In addition, the process pulls the accountants themselves from the specific financial oversight responsibilities of their designated role within the company.

But the reality is that most mid-range and larger manufacturing businesses simply cannot afford to ignore the more careful and more precise measurement afforded by the ABC protocol. After all, the information gathered by the accountants is strictly for internal use. As such, it impacts directly the logic and cost structure of unit prices. That defines the company’s profit margin and can determine ultimately the integrity of long-term financial stability.

Terms & Concepts

Activity: In manufacturing, a specific stage of the production process.

Allocate: To divide according to need and/or want rather than evenly.

Cost Objective: The goal of the production process. In manufacturing, the goal is a product or product line. Service industries also have cost objectives.

Cost Pool: In accounting, the collective stage of related activities that form a major stage in the production process and thus require both time and money investments.

Data-Intensive: In business, a position and/or department driven by an accumulation of information to the point that efficient operation can be compromised.

Overhead: In accounting, the ongoing costs of maintaining a business’s level of operation.

Proportional: That which is divided according to some predetermined logic.

Unit Price: The price of a single commodity, product, or service activity performed by a business.

Bibliography

Ittner, C. D., Lanen, W. N., & Larcker, D. F. (2002). The association between activity-based costing and manufacturing performance. Journal of Accounting Research, 40(3), 711–726. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=6682590&site=ehost-live

Kapic, J. (2014). Activity-based costing. Business Consultant, 6(32), 9–16. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=94088189&site=ehost-live

Lelkes, A-M, & Deis, D. (2013). Using the production time to reduce the complexity of activity-based costing systems. Journal of Theoretical Accounting Research ,9(1), 57–84. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=92952856&site=ehost-live

Ness, J. A., & Cucuzza, T. G. (1995). Tapping the full potential of ABC. Harvard Business Review, 73(4), 130–138. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=9507242793&site=ehost-live

Park, J., & Simpson, T. W. (2008). Toward an activity-based costing system for product families and product platforms in the early stages of development. International Journal of Production Research, 46(1), 99–130. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=27529836&site=ehost-live

Phan, T. N., Baird, K., & Blair, B. (2014). The use and success of activity-based management practices at different organisational life cycle stages. International Journal of Production Research, 52(3), 787–803. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=94003962&site=ehost-live

Tsai, W., Tsaur, T., Chou, Y., Liu, J., Hsu, J., & Hsieh, C. (2015). Integrating the activity-based costing system and life-cycle assessment into green decision-making. International Journal of Production Research, 53(2), 451–465. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=99546434&site=ehost-live

Wei Tong Chen. (2016). Application of activity-based costing on reinforcing steel bar manufacturer. International Journal of Organizational Innovation, 9(1), 228–243. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=116828300&site=ehost-live

Activity-based Costing (ABC)

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Subject Terms

Activity-based Costing (ABC)

Abstract

Overview

Applications

Viewpoints

Terms & Concepts

Bibliography

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