Activity-Based Costing: A Methodology for Costing and Profitability

Article excerpt

In today's economic and highly competitive marketplace, the ability to identify costs of product and operation activities has become crucial. Without accurate costing information, companies lack the ability to make informed decisions.

While identifying, analyzing and managing costs is no simple task, many companies have discovered a method to do just that. These companies are employing activity-based costing (ABC).


The current challenge in cost management is the ongoing change in the makeup of direct and indirect costs. Over the last 10 to 20 years, the nature of manufacturing and, consequently, costs has evolved. For example, the term "lights out factory" means something totally different today than it did only 15 years ago. While it would have meant a plant that was closed for vacation or retooling in the past, today it refers to an automated factory that requires little lighting because there are few (or no) people.

Traditional costing methods grouped automation, information systems and other technologies into allocation pools, such as overhead. Since labor was the most significant and most measured element of the overall product cost, this cost was allocated to products based on labor. While still measured as closely today as in the past, labor is now the least significant cost in many cases.

The emergence of automated processes and information systems in manufacturing has changed the face of costing considerations. New costs, such as energy and systems maintenance, have emerged as significant elements in product costing. In these instances, closely measuring labor, while allocating other costs like energy based upon percentages of labor, can lead to a highly distorted and inaccurate picture of product costs. Decisions made against costs based on these practices can reduce profit.


ABC can help meet the challenge of the changing cost mix. Several steps will help someone implement and use ABC.

First, identify the significant cost elements in the organization. This is a crucial task and requires a reasonably accurate assessment of the major pools of cost. However, costs need not be by product or organization, but rather, they must be definitive elements or categories. Examples are material handling costs, energy or maintenance.

The next step is to identify drivers of the most significant costs or those that merit direct control and product cost identity. These drivers are the activities in activity-based costing. Again, this will be no insignificant task. However, when completed it will provide the basis of an effective ABC system. Examples of cost drivers would be machine or kilowatt hours for the energy cost pool; material moves or stationary truck hours for the material handling cost pool; and machine operation hours or production throughput for the maintenance cost pool.

The rate for each activity by cost pool can then be calculated by determining the use of the planned driver (or actual volume of each driver). At this point, the opportunity exists to determine two costs for each product. …