What is activity-based costing?

What activity-based costing is

Activity-based costing (ABC) assigns costs to the activities an organisation performs, and then assigns those activity costs to products, services, customers or orders according to how much of each activity they actually consume.

The idea it replaces is simpler and cruder: traditional absorption costing spreads overhead across output using a volume measure such as labour hours or machine hours. That is accurate when every product consumes overhead in proportion to its volume. It is misleading when complexity varies, because a small, awkward order can consume far more support effort than a large, straightforward one while being charged less overhead.

How the method works

1. Identify the activities. What does the support function actually do? Set up a machine, process an order, handle a customer query, resolve a complaint, expedite a delivery.
2. Assign resource costs to activities. Take the cost of the people, systems and space and attach it to the activities they serve, using time spent as the basis.
3. Choose cost drivers. For each activity, the measure that causes its cost to rise: number of setups, number of orders, number of complaints, number of expedites.
4. Assign activity costs to cost objects. Consumption of the driver multiplied by the rate per driver unit gives the overhead each product, customer or order carries.

Why it exists, in one illustration

A distribution business sells two lines. Line A is high volume and routine. Line B is low volume and awkward: more orders, more part-loads, more queries, more corrections.

• Overhead to allocate: $200,000
• Labour hours: Line A 16,000, Line B 4,000 (total 20,000)
• Traditional allocation at $10 per labour hour: Line A $160,000, Line B $40,000
• The same overhead split by activity drivers: Line A $120,000, Line B $80,000

Same total, same company, a completely different view of which line is profitable. Nothing was measured better in the second calculation; the second calculation simply stopped assuming that support effort rises and falls with labour hours. These figures are an illustration of the arithmetic, not a benchmark from any real business.

What ABC needs to work

ABC depends on activity data: what people did, how often, and how long it took. That is the same information a Capacity Intelligence model captures, and it is the reason so many ABC projects stall.

• Interviews and estimates produce a first pass, then go stale within months.
• System logs cover the system-mediated part of the work and miss everything done in email, meetings and spreadsheets.
• Continuous capture at the point of work keeps the driver rates current, which is what makes the difference between an ABC study and an ABC capability.

Where ABC goes wrong

• Too many activities. A hundred activity codes produce a model nobody maintains and nobody trusts.
• Stale driver rates. Last year’s effort split applied to this year’s process produces confident, wrong numbers.
• Treating it as an accounting exercise. ABC that does not change a decision has cost money and told nobody anything.
• Using it to allocate blame. The point is to see where effort is consumed, not to prove a team is inefficient.

How it relates to the other measures

ABC answers “what does this product or customer really cost to serve?” Utilisation answers “how full were the people?” and friction analysis answers “how much of that time was avoidable?” Used together, they explain the gap between what a service should cost and what it does cost.

Common questions

What is activity-based costing in simple terms?

Instead of spreading overhead by volume, you cost the activities the business performs, then charge products, customers or orders for the activities they actually consume. It stops a complex, awkward order from looking cheaper than it is.

How does activity-based costing differ from traditional costing?

Traditional absorption costing allocates overhead on a volume driver such as labour hours, which assumes every product consumes support effort in proportion to its size. ABC allocates on the causes of the effort, such as number of orders, setups or complaints.

What is a cost driver?

The measure that causes an activity's cost to change: number of machine setups, orders processed, customer queries, expedites or complaints. Cost per driver unit multiplied by consumption gives the overhead assigned.

Which organisations use activity-based costing?

It is most established where product or customer mix varies and support effort is significant: manufacturing, logistics, banking, healthcare and parts of the public sector. Adoption is uneven, and specific companies rarely disclose their internal costing models, so claims that a named company 'uses ABC' are usually not verifiable.

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