Activity Based Costing is an alternative to conventional cost accounting that tries to allocate costs to products, markets and customers to provide a more accurate picture of profitability.
When is it useful?
It is a key strategic tool when your business covers a range of products/services/customers with very different characteristics. This is because knowing where you are currently making money is an essential starting point of any business strategy, and conventional cost accounting can calculate very misleading costs in certain circumstances.
ABC costing moves away from accounting rules in order to create a more accurate picture of how cost is incurred for management decision-making. The most common distortions of normal cost accounting in a multi-product environment are:
- Allocation of overheads based on volume or sales rather than actual usage of key resources
- No accounting for the costs of complexity, systematically underestimating the cost for small orders/segments/volumes and overestimating the cost for high volume business
- No accounting for the differential use of capital, whether fixed assets or working capital
Suppose you make three products.
In the past you have used traditional overhead allocation based on sales. As a result you think that C is your star product and Product A is only breakeven, but absorbs overheads. Therefore you are allocating most of your resources to growing product C while you maintain volumes on Product C.
You conduct an Activity Based Costing analysis. This identifies that Product C is much harder to manufacture and sell than other products, whereas Product A is much easier.
Your recalculated overhead allocation shows that in fact, Product A is your main profit generator, while Product C actually needs so much overhead support that it is unprofitable. You change your resource allocation, driving Product A as hard as you can and creating a 12 month action plan to return Product C to profitability.
You will not make good resource allocation decisions without knowing the ‘true’ profitability of each product/customer/segment/channel/business.
How do you do the analysis?
Activity Based Costing analyses the entire cost and capital base of a business.
Divide the business up into different Activity Centres (e.g. Receivables).
Calculate the full cost of each of these Activity Centres. The entire cost and capital base is allocated to these Activity Centres. Multiple the capital cost by the cost of capital to find an economic cost of this capital used.
Identify a cost driver for that Activity Centre, and therefore the cost per unit of the cost driver. What is the metric that best captures what cost is incurred in this activity? For example, the cost driver for the Receivables Activity Centre could be “Number of invoices”, based on the understanding that it takes a similar effort to process and follow-up an invoice, whether it is for $10k or $1m.
Calculate how much each product (or customer) uses that cost driver – how many invoices does each product line appear on?
Allocate the Activity Centre costs on the basis of usage of the cost driver
Recalculate product or customer profitability based on this new cost allocation
Check your numbers – the total profitability should remain the same after reallocating costs
The final stage is to calculate the total cost of each product by multiplying the usage by the capital and operating cost of each driver across all activity centres in the company.
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