What is activity based costing

Activity Based Costing, also known as ABC, is a budgeting method that allocates costs to different products and services. Activity based costing is a way that you can plan for costs and also control costs. You have to use activity based costing in order to do value chain analysis properly.

The historical development of activity based costing

Traditionally speaking, cost accountants had simply arbitrarily added a percentage of expenses onto the direct costs of a company in order to allow for any indirect costs incurred by the company. The problem is that as the percentage of all indirect costs and overhead costs rises, then simply adding a percentage onto the direct costs becomes more and more inaccurate because inaccurate costs are incurred unequally by different products. So when a number of different products end up having common costs, then you could end up having one product subsidizing another product, which is a problematic issue when it comes to coming up with your budget and determining your costs.

In order to make up for this problem with inaccuracy and product subsidizing, the manufacturing sector came up with activity based costing, or ABC, during the 1970s and the 1980s. The Consortium for Advanced Manufacturing International came up with activity based costing in order to make budgeting and cost tracking more accurate not just within the manufacturing sector, but also within other sectors of the economy.

The methodology of activity based costing

It's pretty easy overall for you to track direct labor and materials. However, it's much more difficult to determine which indirect costs directly are associated with particular products. Because products will use common resources differently, then you need to ensure that when you are allocating costs, you are weighting the indirect use of common resources so that you can better determine how much each product is really costing the company. The cost driver is what will measure the use of a shared activity by each of the different products. There are limitations to your activity based costing, however. It is hard to assign indirect costs and overhead costs to different products and customers. For example, how do you assign the salary of your chief executive? These difficult to assign costs are called business sustaining, and they will not be assigned to particular products or customers because no meaningful assignment method currently exists. All of the products must contribute to meet these unallocated overhead costs.

It is important to remember that the only reason to use activity based costing, or ABC, is to provide information to the management of the company or the corporation. So you should not be arbitrarily assigning costs. Activity based costing is an overall costing model that will help you identify the cost pools, also known as the activity centers, in your business or your organization. It will then assign costs to different products and services based on how many events or how many transactions are involved in providing that product or that service to the customer. So, if managers really want to maximize their shareholder value and really want to improve the overall corporate performance of the company, activity based costing can help you achieve that overall improvement in your company's performance. Particular benefits from activity based costing include being able to identify the most profitable customers and the least profitable customers, the true contributors to your financial performance and the detractors from your financial performance, will help you accurately predict your costs, and your profits, and your resource requirements, and will help you determine what the real reason is for any poor financial performance within your company.

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