Activity Based Costing (ABC)

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


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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.

Activity Based Costing - OverviewContinuous 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.

Activity Based Costing Forum
  What is Process Costing?
In cost accounting systems, what is process costing?...
  What is Job Order Costing?
In cost accounting systems, what is job order costing?...
  Deriving Overhead Cost from the P&L
Hello reader, I'm trying to decompose the overhead of a company through its Profit and Loss account. I have calculated for my self what their overhead should be and I want to compare this with their real time data.
It is a normal P&L with revenu...
  ABC or TOC? The Differences between Activity Based Costing and the Theory of Constraints
In past literature, the Theory of Constraints (TOC) has been seen as more or less contradicting the concept of ABC-costing and its assumptions.
The main contradictions between ABC and ...
  Comparison Activity Based Costing, Time-Driven-ABC and Lean Accounting
In the article "Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences Among Three Accounting Systems", 3 ways of accounting are compared. The comparison is made on three factors: 1: Decision making, 2: Fin...
  An ABC Initiative is Only as Effective as the Software That Supports It
For any change initiative or performance improvement initiative that is taken in an organization, it is always important that the goal of the initiative has to be finalized first. This is true for Activity Based Costing (ABC) initiative also. While f...
  Calculating the Most Profitable Way of Manufacturing a Product
Dear all, I am struggling with the start of a project in which I need to figure out what way of supplying a customer with a certain product is most profitable (from buying raw materials till delivering to the customer)...
We manufacture ...
  Traditional Costing versus Activity Based Costing
When should I choose the traditional costing instead of ABC?
Compared with traditional costing, what are the drawbacks of ABC?...
  ABC in an Advertising Firm?
How can ABC be applied in an advertising firm where activities vary per project, depending on the client, its marketing campaign, its objectives, and their budget?...
  Capacity Minutes and Industry Norms
Productivity levels in minutes - productive time
Work days are about 480 minutes (8 x 60). Where could I find what the industry norms are? Are there examples that show the average for the industry to be for example 60% capacity (288 minutes) or ...
  ABC Helps Companies Survive Recession
Companies using ABC costing have a better chance of surviving the recession than companies using traditional methods. Please give your comments....
  Overhead 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....
  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....
  Time-driven ABC (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....
  Fixes for ABC Shortcomings
How can ABC shortcomings be effectively addressed?...
  Activity Based Costing Implementation
How can a company implement activity based costing?...
  ABC and Decision making
Are managers able to make better decisions through the analysis of indirect cost allocation?...
  Activity Based Management (ABM)
What is the modern term or second name for Activity Based Costing?...
  Organizational Aspects of ABC
What organisational/behavioural problems can arise when ABC is introduced?...

Activity Based Costing Special Interest Group

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Activity Based Costing Education & Events

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Best Practices - Activity Based Costing Premium
  Recommended ABC Software
Which software package would you recommend I use in our small business to enable me to setup an ABC-system?...

Expert Tips - Activity Based Costing Premium

4 Steps to Assign Resources to End Products

There are basically 4 steps in assigning production resources to end products:
1. Define Activity Groups, having a direct relation with end produ...
Usage (application): ABC Implementation

Disadvantages of ABC

Following disadvantages can be associated with the application of Activity Based Costing:
- Cost effectiveness: Cost effectiveness represents a ...
Usage (application): Cost Mgt, Decision-making

Applicability in Hotel Bussiness

In recent years, cost accounting systems have been replaced by Activity Based Costing systems in the manufacturing sector.
But in spite of this ...
Usage (application): Cost Management, Decision-making

Application Challenges of ABC

When applying Activity Based Costing to real world operations, companies face different challenges.
- One of the challenges is the recognition th...
Usage (application): Cost Mgt, Decision-making

Resources - Activity Based Costing Premium

Time-Driven ABC

Paper by Robert S. Kaplan and Steven R. Anderson. The traditional ABC model has been difficult for many organizations to implement because of the high...
Usage (application): Activity Based Costing

Activity Based Costing and Activity Based Management

This presentation explains the concept of Activity Based Costing (ABC) and also explains an additional form of ABC: Additional Based Management (ABM)....
Usage (application): Accounting, Costing Systems

Costing Strategies

Paper by Marco Agliati argues that in a globalization context, it becomes of pivotal importance being able to make cost comparisons on homogeneous bas...
Usage (application): Multinational Companies

Interview with Kaplan: ABC in the Public Sector

Interview with Robert S. Kaplan, in which he discusses an example that led to a 35% cost reduction in the public sector after using Activity Based Cos...
Usage (application): Understanding that Activity Based Costing can be applied to the public sector

ABC Diagram

Download and edit this 12manage PowerPoint graphic for limited personal, educational and business use. Republishing in intranets, websites, books, ma...
Usage (application): Activity Based Costing


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