Activity Based Costing
(ABC)

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Analyzing product and customer profitability. Explanation of Activity Based Costing.

Activity Based Costing (ABC) is an alternative to the traditional way of accounting. Traditionally it is assumed that high volume customers are profitable customers. A loyal customer is also a profitable customer. And profits will follow a happy customer. Studies about customer profitability have unveiled that the above ideas are not necessarily true. ABC is a costing model that identifies the cost pools, or activity centers, in an organization. It assigns costs to products and services (cost drivers), based on the number of events or transactions that are taking place in the process of providing a product or service. As a result, Activity Based Management can support managers to see how shareholder value can be maximized and how corporate performance can be improved.

Historically, cost accounting models related indirect costs on the basis of volume.

Typical benefits of Activity-Based Costing:

Identify the most profitable customers, products and channels.
Identify the least profitable customers, products and channels.
Determine the true contributors to- and detractors from- financial performance.
Accurately predict costs, profits and resources requirements associated with changes in production volumes, organizational structure and costs of resources.
Easily identify the root causes of poor financial performance.
Track costs of activities and work processes.
Equip managers with cost intelligence to stimulate improvements.
Facilitate a better Marketing Mix
Enhance the bargaining power with the customer.
Achieve better Positioning of products

With the costing now based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer, one can arrive at customer's profitability. This method of dealing separately with the customer costs and the product costs, enables the identification of the profitability of each customer. And Positioning the products and services accordingly.

Continuous Improvement

The implementation of ABC can make the employees understand the various costs involved. This will then enable them to analyze the cost, and to identify the activities that add value and those that do not add value. Finally, based on this, improvements can be implemented and the benefits can be realized. This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the non value added activities and to achieve an overall efficiency.

ABC has helped enterprises in answering the market need for better quality products at competitive prices. Analyzing the product profitability and customer profitability, the ABC method has contributed effectively for the top management's decision making process. With ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. Many companies also use ABC as a basis for a balanced scorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for continuous improvement. With Activity Based Costing any enterprise can have a built-in competitive cost advantage, so it can continuously add value to both its stakeholders and customers.

The implementation of Activity Based Costing is not easy - not an ABC. Special activity based costing software can be helpful.

Time-Driven Activity-Based Costing

Robert Kaplan and Steven Anderson have suggested Time-Driven Activity-Based Costing. This is a new approach to avoid the difficulties associated with large-scale ABC implementation (HBR November 2004). In this revised model, managers estimate the resource demands of each transaction, product, or customer, rather than relying on time-consuming and costly employee surveys. The Time-Driven Activity-Based Costing method is simpler since it requires, for each group of resources, estimates of only two parameters. 1. What are the costs per time unit of capacity to supply resources to the business activities? (The total overhead expenditure of a department divided by the total employee time available). 2. An estimation of the unit times of activities: how much time it takes to carry out one unit of each kind of activity (as estimated or observed by the manager). This Time-Driven ABC approach also overcomes a serious technical problem associated with employee surveys: employees invariably report percentages that add up to 100, when they are asked to estimate time spent on activities. Managers should take into account time that is idle or unused. The method also supports time equations, a feature that enables the ABC model to approximate the complexity of real-world operations. By showing how specific order, customer, and activity characteristics cause variation in processing times.

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Recent User Comments

    			 
             Sara Wietecha - USA
  	       
  		     Overhead on Costing - Food Manufacturing
  	  		 "The company I work for manufactures food. The company is small. How much overhead should I count into my costing. I do not want to put too much in so I don't overcharge the customers when I price them."
  			   
    	  		 0

    			 
             Stander - SA
  	       
  		     ABC Software
  	  		 "Which software package would you recomment I use in our small business to enable me to setup an ABC-system?"
  			   
    	  		 3

    			 
             Will - USA
  	       
  		     ABC in the Federal Environment
  	  		 "Does anybody have experience implementing ABC in the federal environment? There are obviously a lot of differences, but the same benefits can be reaped from determining the costs of performing certain activities. Thanks."
  			   
    	  		 0

    			 
             William (Bill) Clark - USA
  	       
  		     TDABC
  	  		 "Is anyone using TDABC as a substitute for traditional activity-based costing?  I would love to discuss how it's working, implementation tactics, etc."
  			   
    	  		 0

    			 
             Fade, Abiodun - Nigeria
  	       
  		     Fixes for ABC Shortcomings
  	  		 "How can ABC shortcomings be effectively addressed?"
  			   
    	  		 0

Best User Comments

    			   
    			     XY - Singapore
  	         
  				   Limitations and Advantages of ABC
  				   "What are the limitations and advantages of ABC in the context of preparing plans and budgets?"
    			   
        	  		 134

    			   
    			     Jay - Singapore
  	         
  				   Limitations ABC monitoring operations
  				   "What are the limitations with regard to monitoring and controlling operations?"
    			   
        	  		 83

    			   
    			     Rudi - Switzerland
  	         
  				   Use of ABC Costing
  				   "The following is a quote from the beginning of a serious article about ABC. The article goes on to analyze and show what methods are best for decision making.

"It would be better "to slaughter a farm animal and read its entrails" than to use activity based costing for decision-making.""
    			   
        	  		 28

    			   
    			     Reyn - Phil
  	         
  				   Non-value-added activities
  				   "Why do non-value activities cause costs to increase unnecessarily?"
    			   
        	  		 26

    			   
    			     Sharon - Israel
  	         
  				   Question on ABC
  				   "If Activity-based Costing has been correctly implemented, and it turns out a product is causing losses, does this mean automatically that the product should be discontinued?"
    			   
        	  		 24

    			   
    			     Manwel - Lebanon
  	         
  				   Drivers still Right?
  				   "ABC is one of the most recent developed evolution in costing. It has a big impact in allocating the cost to the right object... but still the question is: to what extent are the drivers right and effective? Does ABC require ongoing update of drivers?"
    			   
        	  		 21

    			   
    			     Michelle - USA
  	         
  				   Assigning costs of resources
  				   "There are basically 4 steps in assigning production resources to end products: 1. Define Activity Groups, having a direct relation with end products 2. Determine Resource Drivers (these show the relation between production resources and activities groups) and determine Cost Drivers (show the causal relation between an activity group and a type of end product) 3. Assign the costs and resources to activities based on the Resource Drivers 4. Assign the costs of activity groups to end products based on the Cost"
    			   
        	  		 20

    			   
    			     Kity - Mauritius
  	         
  				   ABC: reduce non value adding activities?
  				   "How far do you agree that Activity Based Costing gives opportunities to reduce or eliminate activities that do not add value in a highly competitive environment?"
    			   
        	  		 19

    			   
    			     Mark - UK
  	         
  				   Conditional Resources in ABC
  				   "How does ABC cater for estimating the cost of business processes which may take many different routes depending on the outcome of decisions or events - for instance, a resource may only be used once in every hundred runs of the process, therefore is only 1% of the resource cost included in the estimate??"
    			   
        	  		 15

    			   
    			     Chal - Ethiopia
  	         
  				   ABC in service companies such as airlines?
  				   "ABC may be appropriate in the manufacturng company, but I doubt applying in service givng companies is worth while. Especially in the airline industry where there are various types of common costs and too much different types of activities. Hence can ABC be applicable to the service rendering company?"
    			   
        	  		 14

    			   
    			     PWCoopers - England
  	         
  				   Activity Based Costing (ABC)
  				   "Company's who use ABC method have a more chance in surviving under recession rather than company's who use Traditional Based Costing."
    			   
        	  		 11

    			   
    			     Amir - Iran
  	         
  				   university professor
  				   "As I did in my master thesis and I have seen over and over in CRM articles, many scolars believe that this is the best way to understand who are the profitable customers and this technique is so applicable comparing with conventional accounting or costing and it would be better to modify it with some notes to customer relationship management and customer profitability analysis."
    			   
        	  		 11

    			   
    			     rahul_6098 - India
  	         
  				   The Process of ABC simplified
  				   "While doing ABC the only thing to be kept in mind is the activity and the cost associated with it.
For ex. : A person buys a bus for using it in his public transport business. So he will analyse the cost associated with procurement of bus. Then he will have to analyse the cost of getting a driver, everyday fuel consumption, maintainance, contingencies. Now suppose if he already is in business, thus, by ABC, he can eliminate all the unnecessary steps which adds to cost but didn't add any value to the product. ABC is a very helpful tool if you have clarity of ABC and the process under observation."
    			   
        	  		 9

    			   
    			     Simon - Australia
  	         
  				   Degree of Detail in ABC
  				   "When planning to build an ABC model it is essential to first make the decision what level of detail ABC is to be captured. This depends on what questions are to be answered:

1. Strategic (about 100-150 Activities). This is the most common application and is used to deliver customer and product profitability and visibility where the costs are incurred.

2. Operational (500+ Activities). At this level, individual tasks are captured and these models are commonly used for process improvement."
    			   
        	  		 9

    			   
    			     AY - Uzbekistan
  	         
  				   ABC and Decision making
  				   "Are managers able to make better decisions through the analysis of indirect cost allocation?"
    			   
        	  		 6

    			   
    			     Richard van Breukelen - The Netherlands
  	         
  				   Time-driven ABC
  				   "Dear members of the special interest group ABC,

As consultant I graduated at Tilburg University (The Neterlands) in 1992 on an ABC problem at a European distribution center.

I wonder if the later formulated time-driven ABC is useful or if it is 'old fashioned'. If the answer is 'it is still useful and profitable for customers, can you give me examples / industries where recently time-driven ABC has been implemented succesfully?
Thanks a lot."
    			   
        	  		 6

    			   
    			     Zaheer - India
  	         
  				   ABC Costing in Manufacturing
  				   "I think ABC costing works better only in repetitive manufacturing type of industry, where the amount of production in a given period is steady.

Whereas in a make to order environment ABC may not work well, because the profit and expenditure have to be tracked by order. One order may last for several perods."
    			   
        	  		 4

    			   
    			     Saidnumon - Uzbekistan
  	         
  				   ABC
  				   "What is the modern term or second name for Activity Based Costing?"
    			   
        	  		 2

    			   
    			     AJ - Ireland
  	         
  				   Organizational Aspects of ABC
  				   "What organisational/behavioural problems can arise when ABC is introduced?"
    			   
        	  		 2

    			   
                 Rose - Lesotho
  	         
  				   Activity Based Costing Implementation
  				   "How can a company implement activity based costing?"
    			   
        	  		 0

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12manage for:

                     
                      └► E. Davydov (Russia)
                      
                    ABC System Selection
                    "Hi, it depends on:

1) The size of your organization.

2) Organization specific issues.

3) ABC accuracy (is it enough to have 70%?).

4) Your purpose of using ABC."

                     
                      └► William (bill) Clark (USA)
                      
                    Implementing ABC in Gov/Mil
                    "I'm in the process of building an ABC model for the logistics centers for the US Coast Guard. As a quick overview, I would say activites, process improvement and efficiencies are the focus of the model (some outsourcing comparisons may also be available) and not profit."

└► KTK (India)	ABC limitations and benefits	"This is a very good query. When we look at ABC for the estimation of plans/budgets, the major limitation is not having a proper estimation of the costs for some critical activities such as R&D. The second limitation in using ABC for plans/budgets is a result of the first, i.e. when we miss out proper estimation of the costs for one activity that results in breakdown in the whole chain of activities. Though there are many advantages, by which we can always overcome the limitations, I would like to mention the following two: Adv 1: When we carry out planning/budgeting based on ABC we can always have more accurate estimations being done. Adv 2: We can always figure-out where our estimations went wrong, since we know what each activity contributed in our planning/budgeting. ABC is the basis for Zero Based Budgeting(ZBB) and ZBB has yielded good results in many big organizations."
└► Rajendra (India)	ABC Limitations	"KTK,XY the use of ABC for planning and budgeting is supposed to be for the activities that are related to the volume of the products sold. For other parts the planning and the budgeting should be based on the projects that are to be taken in that function. Like in R&D function."
└► neelam chand (Fiji)	Accounting	"very beneficial site"

                       
                        └► Grace (Singapore)
                        
                      Limitations ABC monitoring Operations
                      "ABC is the basis for the control of the efficiency of processes or activities being performed, by signalling a number of key measures of performances which should be monitored if costs and the business generally are to be controlled."

	└► Shabs (Oman)	Uses of Activity Based Costing	"What are the uses and usefulnes of Activity Based Costing (ABC)?"
	└► VIJI (INDIA)	ABC	"You get slaughtered any way"

                       
                        └► Joseph (Philippines)
                        
                      Non-value Adding Activities
                      "The more non-value adding activities you do, the more costs you will incur. Since your activities are not adding any value, this cost increase is unnecessary."

└► vijay (india)	activity based costing	"The product should not be discontinued. To produce that particular product (in spite of loss) could be a strategic decision. For example, you get order for say 5 products which includes the 'loss making' product. The order says you supply all or nothing. Now, if the order, taking in to account all 5 products, is profitable then it makes sense to produce and supply the 'loss making' product. Same logic can be extended to a profitable customer also. In order to retain him and earn profit on sales to him at the end of the year, you might have to sell the 'loss making' product along with other profitable products."
└► Jake (USA)	Loss-making products	"Agree with Vijay: there can be strategic or other valid reasons to continue the product, even if a correct ABC analysis shows it is causing losses. Of course we should investigate if there are other (more profitable) ways to manufacture the product or to keep the customer."
└► Simon (Australia)	Loss-making products	"Firstly one should never make the fatal mistake and discontinue unprofitable products and customers without thorough investigation. There are valid reasons, why one should continue unprofitable products some mentioned above: 1. All products, even unprofitable ones absorbe fixed costs. Even if such a product was discontinued, these fixed costs would remain within the business and depending on the fixed vs variable cost split to supply this product, overall profit could suffer. 2. It is a strategic "loss-leader" product that is sold in combination with profitable products. Once one has determined that an unprofitable product needs to be continued the following profit optimising steps should follow: 1. Assess if a price increase is possible to make the product more profitable. 2. Investigate if the product can be sold in bulk to reduce transaction costs. 3. Investigate if the product can be manufactured / sourced at lower costs."
└► Kostadin Nedyalkov Krastev (Bulgaria)	Analysis	"Conversion costs are constraining the product mix. Product and customer sustaining activities can be reorganized to make a better branding. Customer repetitive actions on the profitable products,v95% of the costs for the unprofitable products must come from the unit and batch costs,vthen the goal must be minimizing the direct batch costs(making combinations with other products or buying some components), other decision maybe to make relationships with suppliers who can supply the product and making a minimum margin on the product. You all must always minimize all fixed or semi-fixed costs or I would say also constrained variable resources on the less profitable or unprofitable products and try to redistribute them to the profitable ones. You may set goals - if the trend is that for example in 70-80% or more of the orders in which the unprofitable product is bought and this product is 10-15 % or less of the order price, you have good margins."

                       
                        └► Maggie (China)
                        
                      Activity Based Costing Limitation
                      "Cost drivers are not easy to define and obtain."

	└► Youri (UK)	Identifying Value in Activities	"You need to look more towards VSM if you want to identify value in activities. ABC even if it is time based is no more then creating an insight in where costs are derived."
	└► Kooshraj (Mauritius)	Value added output of ABC	"Indeed ABC, will enable any organisatin to have a better view of all processes and procedures which enables the following: - Streamlining of processes - Identification of expensive cost drivers -"

                       
                        └► Charles (UK)
                        
                      Conditional Resources
                      "Most ABC/M models are built using real transactional or operational metrics extracted from the business OLTP systems as the basis for assignment. So if the data indicates that the resource was used 99% of the time for process A, and only 1% for process B, the model should reflect this."

└► Scott (USA)	ABC in Service companies such as airlines	"Actually, ABC works quite well for allocating costs to airlines. I've built a model that does exactly that, using a few basic activity drivers, that results in allocating an airline's cost to each seat in its route. I'm sure that ABC works well in other service industries as well."
└► lil (Canada)	How?	"i wonder if company such as airport can use ABC?"
└► Dattatraya Bhanudas Nikam (India)	Implementation of ABC	"Is there anybody who have implemented the ABC in manufacturing industry. I'm having some doubts in this regard. Bye. Datta"

	└► Brandon (UK)	ABC vs TBC	"Activity Based Costing method is more accurate for costing of products / services, customers. It also makes wastes visible where as company's can take action. The disadvantages are it is time consuming and expensive. Overall the pros outweigh the cons, even my wife feels ABC method can be used in the bedroom to eliminate any wastes and taking time (time consuming) is better."
	└► CHEN Patrick (China)	A Real World Example of ABC	"Dear Brandon, Actually, i'm learning ABC. You said your wife used ABC in the bedroom, could you make it detailed? Because I think a real life example other than business examples can help me understand ABC more deeply. Thanks a lot!"

                       
                        └► Marcel Wiedenbrugge (Netherlands)
                        
                      ABC - CRM
                      "You are absolutely right. ABC is strongly related to optimising the value of your customer portfolio (especially in B2B). The main question is: on which customer do you need to spend time and money (from a long term profitability pov)."

	└► Enzo (Argentine)	ABC-Planning	"This depends on: 1) For one special sector it is very few probable to summarize the information.. I explain: in one sector in South America it is impossible to work with a lot of dates the one activity or reverse position more activities, few and less dates. 2) It is very interesting to applicate the ABC system when the firm has experience and the possibilities to create competitive advantages."
	└► jC (Singapore)	Why ABC?	"As a management tool, ABC is useful to certain organizations only. It depends on the type of management style the organization is adopting. The cost of implementation is high and the neccessity of having so much activities are questionable too. An effective and efficient ABC implementation depends highly on how it fits to the organization culture and management methods. A good ABC implementation should include only adequate activities and ignore immaterial activities - focus on systematic way of generating data from the activities - the costs vs benefits analysis must conducted."

                       
                        └► Editor (Netherlands)
                        
                      Modern term for ABC (Synonym): ABM
                      "A more recent term you see used for ABC is Activity Based Management (ABM). I believe it is mentioned also in the text of the article."