Activity-based costing

Activity-based costing (ABC) assigns costs to products or services according to the resources and activities they actually consume. Earlier accounting systems commonly distributed overhead across product lines in proportion to a direct-cost measure such as labour hours. Although easy to administer, that approach could seriously distort the cost of making individual products. ABC is designed to correct those distortions.

When to use it

• To establish a more accurate view of the cost of manufacturing each product.
• To allocate shared overhead more credibly in complex production settings where many products draw on the same inputs.

Origins

ABC has intellectual roots in George Staubus’s work on activity costing and input-output accounting. Its modern development is also associated with Keith Williams, then a cost-accounting manager at John Deere. In 1984, Williams tested a different way to allocate overhead; within several years, the resulting cost information proved sufficiently useful for the method to spread to companies including GM and Weyerhaeuser. The approach then attracted the attention of Harvard professor Robert Kaplan and Robin Cooper, who helped establish the name “activity-based costing.” Their research, teaching and publications accelerated its adoption, and ABC became a standard method for assigning costs in manufacturing environments.

What it is

ABC produces a more realistic unit-cost estimate by connecting overhead to the factors that cause it. Under traditional absorption costing, utilities, building maintenance and head-office functions such as marketing or customer support are allocated to product lines using a direct-cost base. This was more defensible when materials and labour represented most manufacturing expenditure and indirect costs were relatively modest. Automation, greater product complexity and customisation changed that relationship: two products with comparable direct costs can demand very different levels of overhead.

Consider a standard machine assembled on an automated line and a customised machine that consumes roughly the same materials and labour. The customised version is likely to require substantially more design work, testing and quality control. Allocating overhead from direct costs alone would therefore overstate the standard machine’s cost and understate the customised machine’s cost. Those errors can lead to poor pricing and investment choices and, ultimately, weaker profitability.